Articles

Foreign Account Reporting Using Form 8938--Has the Service Created Compliance Traps?

Fri, 11 Jan 2013 16:08:23 +0000

Foreign Account Reporting Using Form 8938 --
Has the Service Created Compliance Traps?

By: Kevin E. Packman

KEVIN E. PACKMAN is a partner in the Miami office of the law firm of Holland & Knight LLP, and has previously written for The Journal.

Copyright © 2012, Kevin E. Packman.

A new reporting obligation for taxpayers with foreign accounts, in addition to the now relatively well-known FBAR, may be ignored or dismissed by taxpayers unfamiliar with the new requirements and the accompanying penalty provisions. The government is quite serious, however, and taxpayers will run considerable risks if they fail to comply.

U.S. law requires taxpayers who own foreign assets, have a connection to foreign entities, or who engage in foreign activities to report such assets, entities, and activities to the IRS. Taxpayers who fail to file the appropriate information forms risk being subjected to significant monetary penalties. The Foreign Account Tax Compliance Act (FATCA) FN1 increases the number of required information forms by two. FATCA section 521 amended the Code to require shareholders in a passive foreign investment company (PFIC) to file an annual information return disclosing their ownership of the PFIC.FN2 FATCA section 511 added new Section 6038D , creating a new annual filing for U.S. taxpayers with specified foreign financial assets (SFFAs).

Form 8938, which taxpayers will use to meet the Section 6038D requirement, is only the newest--and by no means the only or last--information return that applies to individuals with foreign assets. Statistically speaking, it is likely that more than a few taxpayers, and probably those who are new to the U.S. or live abroad, will run afoul of the U.S. tax rules--and perhaps Form 8938.

BACKGROUND

Section 6038D reads pretty clearly. It requires individuals who hold an interest in a specified foreign financial asset during the tax year to attach to their tax returns the required information if the aggregate value of the SFFAs exceeds $50,000 or such higher threshold as IRS may determine.

The reporting obligation applies to assets held during tax years beginning after FATCA's 3/18/10 effective date. For calendar-year taxpayers, this requires Form 8938 to be attached to their 2011 income tax returns filed during 2012.

In an effort to assist taxpayers with preparing this form, Treasury released Temporary Regulations (TD 9567, 12/14/11) approximately 19 months after the legislation was enacted, which are effective for tax years beginning after 12/19/11. Then on 2/29/12, IRS posted guidance in the form of 14 FAQs discussing the breadth of the filing obligation. FN3

Form 8938 history. The IRS initially released a draft version of Form 8938 in July 2010, but there were no accompanying instructions. A revised draft Form 8938 was released in June 2011, again without instructions.

About the same time that the revised June 2011 draft Form 8938 came out, the Service issued Notice 2011-55, 2011-29 IRB 53 , relieving taxpayers of the filing requirement until such time as Form 8938 was officially released. The Notice also indicated that the IRS intended to issue Regulations for Section 6038D. On 10/3/11, the IRS finally posted draft instructions. These instructions provided transitional rules that essentially relieved taxpayers of the requirement to file Forms 8938 until 2012. (If a taxpayer had a 2011 filing obligation, the form for such year would be filed in 2012, along with any required 2012 form.)

SPECIFIED INDIVIDUALS

The Form 8938 obligation applies only to specified individuals with ownership in an SFFA. Not all persons with such ownership have a filing obligation, however. Temp. Reg. 1.6038D-1T(a)(2) makes clear that the following individuals are specified individuals for Section 6038D purposes:

(1) U.S. citizens.
(2) Permanent residents (i.e., green card holders).
(3) Individuals satisfying the "substantial presence" test. FN4
(4) A nonresident alien making an election to file a joint income tax return with a U.S. spouse.
(5) A nonresident alien who is a bona fide resident of a U.S. possession. FN5

Even if a permanent resident or substantially present resident elects to be treated as a foreign resident under an income tax treaty, that person continues to be a specified individual, and Form 8938 must be filed. It would appear that the permanent resident always will be required to file, but it remains unresolved as to whether Form 8938 must be filed by a substantially present taxpayer who is able to qualify as a nonresident alien under the "closer connection" test. FN6

Nevertheless, despite a specified individual's having ownership in an SFFA in excess of the filing threshold, the Form 8938 obligation does not exist unless the specified individual is required to file either Form 1040 or Form 1040-NR. As a result, not all bona fide residents of a U.S. possession who own the requisite SFFA will have a Form 8938 filing obligation. FN7

Domestic entities. Section 6038D(f) states that the IRS may apply the reporting requirement to domestic entities formed or availed of for purposes of holding, directly or indirectly, SFFAs. This filing season, however, there is no requirement for a domestic entity to file a Form 8938. Nevertheless, Prop. Reg. 1.6038D-6(a) (REG-130302-10, 12/14/11) would bring certain domestic entities-- corporations, partnerships, and trusts--within the purview of Section 6038D , and thus require the filing of a Form 8938. If finalized, the Proposed Regulations will apply for tax years beginning after 2011. The determination as to whether such a domestic entity is availed for the stated purpose of holding an SFFA would be made annually.

INTEREST IN AN SFFA

Under Temp. Reg. 1.6038D-2T(b)(1), a specified individual is defined to have an interest in an SFFA if that person reports on her tax return any income, gain, loss, deduction, credit, gross proceeds, or distribution attributable to the holding or disposition of the asset. Specified individuals still can have an interest in an SFFA, however, even if no income, gain,loss, deduction, credit, gross proceeds, or distribution is attributable to the holding or disposition of the asset during the tax year.

If a parent makes an election under Section 1(g)(7) to include her child's unearned income on the parent's tax return, the parent is deemed to have an interest in any SFFA held by the child. FN8

Because the Proposed Regulations are not yet effective, a specified individual is not deemed to have an interest in an SFFA held by a partnership, corporation, trust or estate, solely as a result of the taxpayer's being a partner, shareholder, or beneficiary. FN9 A specified individual who owns a disregarded entity, however, must file Form 8938 if the entity owns an SFFA. Similarly, if the specified individual owns any part of a grantor trust (other than a bankruptcy liquidating trust or a domestic widely held fixed investment trust), the taxpayer is deemed to own any SFFA held by the trust. FN10

FILING THRESHOLD

Specified individuals who own SFFAs are obligated to file a Form 8938 if the total value of those assets exceeds a threshold. The amount of the threshold varies depending on the filing status of the taxpayer. Additionally, the filing status is premised on the high value or year-end value exceeding certain thresholds. For single taxpayers living in the U.S., the high value threshold is $75,000, and the year-end value threshold is $50,000. -end value threshold is $50,000. FN11 The thresholds are the same for married taxpayers living in the U.S. who file separate returns. For married taxpayers living in the U.S. and who file a joint return, however, the high-value threshold is doubled to $150,000 and the year-end value threshold is doubled to $100,000. FN12

The filing thresholds are more generous for taxpayers living abroad. If the taxpayer is a bona fide resident of a foreign country, which is defined as living uninterrupted in the foreign jurisdiction for an entire tax year or for at least 330 full days during a tax year, the high-
value threshold is $300,000 and the year-end value threshold is $200,000 so long as the taxpayer does not file a joint income tax return. FN13 This level applies to both single taxpayers and those who are married but file separate returns. The high-value threshold is
$600,000 and the year-end value threshold is $400,000 for married taxpayers who live abroad, file a joint return, and satisfy the foreign residency requirements described above. FN14 These filing thresholds are summarized in Exhibit 1.

Exhibit 1. Summary of Form 8938 Filing Thresholds

Taxpayers have a Form 8938 filing obligation if they meet the thresholds in either the year-end or high-value column.

12/31 aggregate value High annual
of all SFFAs exceeds balance exceeds

Single living in U.S.                                   $ 50,000                                    $ 75,000
Single living outside U.S.                            200,000                                     300,000
Married filing joint returns, living in U.S.        100,000                                     150,000
Married filing separate returns, living in U.S.    50,000                                      75,000
Married filing separate returns,
living outside U.S.                                       200,000                                     300,000
Married filing joint return, living outside U.S. 400,000                                      600,000

When an SFFA is jointly owned, the rules for determining if a taxpayer has exceeded the thresholds depend on the identity and filing status of the joint owners. For example, if the joint owners are married, are specified individuals, and file separate returns, each owner includes 50% of the asset's value when computing the total value of their SFFAs. FN15 When it comes to filing Form 8938, however, each spouse has a separate Form 8938 filing obligation and is required to report 100% of the jointly held asset, not the 50% value used when computing the threshold. FN16 If the joint owners are both specified individuals who file a joint income tax return, they must file one Form 8938 reporting each SFFA owned by either of them. FN17 If the joint owner is a spouse who is not a specified individual, then the specified individual includes 100% of the asset's value when computing the threshold and reports 100% of the value on Form 8938. FN18 Similarly, if the joint owner is not a spouse and both owners are specified individuals, each includes 100% of the asset's value when computing the threshold and reporting the asset. FN19

WHICH FOREIGN ASSETS ARE SFFAs?

SFFAs include both foreign financial accounts and other foreign assets.

Foreign Accounts

The most notable SFFA is a foreign financial account. For purposes of Section 6038D , the account must be "maintained" (a term not defined in the statute or Regulations) by the foreign financial institution. "Financial account" and "foreign financial institution," however, are defined by reference to the withholding provisions in Section 1471 .

Under Section 1471(d)(2), a financial account includes any depository or custodial account maintained by a financial institution. It also includes any equity or debt interest in a financial institution (other than interests which are regularly traded on an established securities market).

Section 1471(d)(5) provides that a financial institution is an entity which:

(1) Accepts deposits in the ordinary course of a banking or similar business;

(2) Holds financial assets for the account of others as a substantial portion of its business; or

(3) Is engaged or holds itself out as being engaged primarily in the business of investing, reinvesting, or trading in securities (as defined in Section 475(c)(2) without regard to the last sentence thereof), partnership interests, commodities (as defined in Section 475(e)(2)), or any interest (including a futures or forward contract or option) in such securities, partnership interest, or commodities.

Even though Section 1471(d)(4) specifically excludes a foreign financial institution organized under the laws of a U.S. possession from the withholding regime, an account located within a U.S. possession is included within the definition of an SFFA. FN20 As such, a specified individual with an account located in a U.S. possession has an SFFA. Notwithstanding that characterization, a specified individual who is a bona fide resident of a U.S. possession is exempt from reporting such account. FN21

Clearly an account held with either a financial institution located in the U.S. or a domestic branch of a foreign financial institution is not an SFFA, as the account is not foreign. An account held with the foreign branch or foreign subsidiary of a U.S. financial institution
also is exempt from the filing requirement. FN22

Foreign Assets

Foreign assets held outside of a financial institution also can be classified as an SFFA. Almost any kind of foreign asset may qualify as an SFFA, such as:

Life insurance or annuities with a cash surrender value.

An interest in an estate.

An interest in a retirement plan.

An account held with a trust company.

Shares in a mutual fund.

An interest in a hedge fund or private equity fund.

Deferred compensation and pension plans held by U.S. expatriates working abroad.

The key is the asset must be held for investment to be reportable. The Regulations note that the categories are broad, and as a result an SFFA may qualify under multiple categories.

Section 6038D(b)(2) includes the following assets held for investment:

(1) Stock or securities issued by a non-U.S. person. FN23

(2) Any financial interest or contract held for investment that has a non-U.S. issuer or counterparty. U.S. taxpayers with foreign family members should be alert that a loan from or to a foreign family member can qualify as an SFFA under this provision.

(3) Any interest in a foreign entity (as defined in Section 1473(5) as an entity that is not a U.S. person).

The Form 8938 instructions and Temp. Reg. 1.6038D-3T(d) provide the following examples of other assets that qualify as SFFAs:

Stock issued by a foreign corporation.
A capital or profits interest in a foreign partnership.
A note, bond, debenture, or other form of indebtedness issued by a foreign person.
An interest in a foreign trust or estate.
An interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement with a foreign counterparty.
An option or other derivative instrument with respect to any of these examples or with respect to any currency or commodity that is entered into with a foreign counterparty or issuer.

As noted above, a foreign asset is reportable if it is held for investment. Temp. Reg. 1.6038D-3T(b)(3) instructs that an asset is held for investment and therefore reportable unless the taxpayer uses it or holds it for use in the conduct of a trade or business. To determine how the asset is used, Temp. Reg. 1.6038D-3T(d)(4) applies, with certain modifications, the asset-use test of Reg. 1.8644(c)(2) (under the rules for determining whether income is effectively connected (ECI) with a U.S. business). Consequently, an asset will qualify for the exception if it is:

(1) Held for the principal purpose of promoting the present conduct of a trade or business. Confusion may exist with whether compensatory stock options are truly held for investment or whether they satisfy this prong of being held for the principal purpose of promoting the business. The Temporary Regulations do not provide clarity since they simply track the ECI rules in determining whether there is a trade or business. Nevertheless, the business is conducted whether the employee receives the stock option or not, which would appear to work against satisfying the principal purpose standard.

(2) Acquired and held in the ordinary course of a trade or business. For example, when the business accrues an account receivable.

(3) Otherwise held in a direct relationship to the trade or business. An asset is presumed to have a direct relationship if it was purchased with assets generated by the trade or business, the income from the asset is reinvested in the business, and employees from the trade or business operate significant management and control over the asset. FN24 Stock will never qualify for the trade or business exception, nor will an asset acquired to help with future diversification or future business contingencies. FN25

Rules for Foreign Estates and Trusts

A specified individual does not have to report a beneficial interest in a foreign estate or foreign trust unless that taxpayer has reason to know of the interest. If the taxpayer receives a distribution from the trust or estate, however, knowledge is attributable to her. FN26

FOREIGN ASSETS EXCLUDED FROM FORM 8938

While it would be impossible to provide an exhaustive list of foreign assets that are excluded from the Form 8938 filing obligation, the following general rules apply.

Real estate, whether developed or rented, is not a reportable asset.

Personal property, such as art work, jewelry, and automobiles, is not reportable.

Foreign currency and payments received by a specified individual in the form of social security, social insurance, or other comparable programs administered by a foreign government do not qualify as an SFFA unless the payments are deposited into a foreign account.

It appears, however, that an unreported asset, such as real estate, may become reportable if the specified individual holds title to the asset through a foreign entity. In addition, if the real estate is leased, while the real estate is not reportable, the lease is likely deemed a contract held for investment, and reportable. If the entity is a disregarded entity or grantor trust, however, the otherwise unreported asset will continue to be exempt from reporting.

The Form 8938 instructions and the Temporary Regulations provide an exemption for SFFAs that otherwise would be reported on more than one information return. In an effort to eliminate duplicative filings, if a taxpayer reports the existence of an SFFA on a Form 3520, Form 3520A, Form 5471, Form 8621, Form 8865, or Form 8891, the asset does not need to be reported on Form 8938. FN27 Nevertheless, the taxpayer still must complete Part IV of Form 8938 and provide the identifying information requested at the top of the form. The duplicative filing exception does not apply to the FBAR.

U.S. possessions. If the specified individual is a bona fide resident of a U.S. possession, and such person has to file a Form 8938, Temp. Reg. 1.6038D-7T(c) excludes the following SFFAs:

(1) A financial account maintained by a financial institution organized under the laws of the U.S. possession where the taxpayer is a resident.

(2) A financial account maintained by a branch of an institution not organized under the laws of the U.S. possession where the taxpayer is a resident, if the branch is subject to the same tax and information reporting requirements that apply to financial institutions in the U.S. possession.

(3) Stock or securities issued by an entity organized in the U.S. possession where the taxpayer is a resident.

(4) An interest in an entity organized under the laws of the U.S. possession where the taxpayer is a resident.

(5) A financial instrument or contract held for investment, if each issuer or counterparty that is not a U.S. person is either an entity organized under the laws of the U.S. possession where the taxpayer is a resident or is a bona fide resident of such U.S. possession.

Consequently, if the specified individual's only SFFAs are those located within the U.S. possession where that taxpayer is a bona fide resident, there is no requirement to file Form 8938. Similarly, recall that if the specified individual does not otherwise have to file a U.S. income tax return, there also is no requirement to file Form 8938.

Dealers. Accounts maintained by dealers or traders in securities or commodities are exempt if all of the holdings are subject to the mark-to-market accounting rules for dealers in securities or an election under Section 475(e) or (f) is made. FN28

DETERMINING VALUE

The value of an SFFA must be computed for two purposes, i.e., (1) determining if the aggregate value of the SFFAs in which the specified individual holds an interest exceeds the threshold, and (2) reporting the maximum value on Form 8938. For both purposes, the asset's maximum value generally is its highest FMV during the tax year. Four general rules apply when determining an asset's value:

(1) All foreign currencies must be converted to U.S. dollars,
(2) FMV is the default valuation,
(3) A value is never less than zero, and
(4) Appraisals are not required.

If the SFFA is a financial account, the specified individual may rely on statements provided by the financial institution (if issued at least annually) unless the taxpayer has reason to know that the statements do not provide a reasonable estimate of the account's maximum value. FN29 Similarly, taxpayers may use the year-end value for an asset that is not a financial account unless they have reason to know that the year-end value does not reflect a reasonable estimate of the asset's maximum value. FN30

If the taxpayer is a beneficiary of a foreign trust, the maximum value is the sum of (1) the total of all distributions received during the tax year from the trust, whether money or property, and (2) the value as of the last day of the taxpayer's right to mandatory distributions, with such distributions valued in accordance with the rules in Section 7520. FN31

If the taxpayer is a beneficiary of a foreign estate, foreign pension plan, or foreign deferred compensation plan, the maximum value is the FMV of the taxpayer's interest as of year-end. If the taxpayer does not know the value or cannot determine the value, the value to be used is equal to the cash and other property distributed to the taxpayer during the year. FN32 If the taxpayer did not receive any distributions during the year, however, the value of the interest is zero.

Foreign currency conversion. Temp. Reg. 1.6038D-5T(c) provides rules for determining value in U.S. dollars. Treasury's Financial Management Service foreign currency exchange rate is used to convert the foreign value of an SFFA into U.S. currency for purposes of both computing the aggregate value of such assets and the maximum value of an SFFA. If there is no Financial Management Service foreign currency exchange rate available for the foreign currency, any other publicly available exchange rate may be used, but the source must be disclosed on Form 8938.

The value of an SFFA for purposes of both computing its aggregate and maximum value is first determined in the local foreign currency. The foreign currency value is then converted into U.S. dollars using the foreign currency exchange rate applicable for purchasing U.S. dollars. The applicable foreign currency exchange rate used is that for the last day of the tax year, regardless as to whether the SFFA was sold during the year.

INFORMATION REPORTED ON FORM 8938

Under Temp. Reg. 1.6038D-4T(a), a specified individual with a Form 8938 filing obligation is required to disclose the following information for each SFFA:

If the SFFA is a foreign financial account, the name and address of the financial institution, the account number, and the date on which the account was opened or closed.

If the SFFA is a stock or security, the name and address of the issuer, other information necessary to determine the class or issue of the stock or security, and the date on which the SFFA was acquired or sold.

If the SFFA is a financial instrument or contract held for investment, the names and addresses of all issuers and counterparties, including information that identifies the financial instrument or contract.

If the SFFA is an interest in a foreign entity, information that identifies the interest, including the name and address of the entity.

The maximum value of the SFFA during the portion of the year in which the specified individual held an interest.

Form 8938 also requests information regarding the taxable income associated with the SFFA, where on an income tax or informational return the information is provided, as well as information on the foreign currency exchange rate used for conversion purposes.

PENALTIES

Taxpayers who have a Form 8938 disclosure requirement will likely also have an FBAR filing requirement. While the penalty for failure to file the FBAR is much harsher than the penalty under Section 6038D for failure to file Form 8938, both of these penalties may be assessed.

Under Section 6038D(d), the minimum penalty for failing to submit the required disclosure is $10,000, and it increases by $10,000 for each 30-day period following notification from Treasury, with the maximum penalty being $50,000. There is, however, a 90-day grace
period following notification from Treasury before the additional $10,000 penalties accrue.

This is similar to the penalties that apply to a failure to file Form 5471 or Form 3520. As with those forms, the penalty may be waived if the taxpayer is able to demonstrate the failure to file was due to reasonable cause. The burden will be on the taxpayer to establish reasonable cause exists. FN33

While the determination will be based on the facts and circumstances of the specific case, it will be difficult to ascertain what standards the revenue agent will use in order for the taxpayer to demonstrate reasonable cause. The fact that a foreign jurisdiction would impose a civil or criminal penalty for disclosing the information will not satisfy reasonable cause. FN34

Married taxpayers filing a joint return who fail to file a Form 8938 are treated as one specified person for penalty purposes, although the liability for the penalty will be joint and several.FN35

For penalty purposes, Temp. Reg. 1.6038D-8T(d) contains a presumption that a specified individual's SFFAs have a value in excess of the filing threshold in the event the taxpayer cannot substantiate the value when requested by the Service.

If the taxpayer underpays tax as a result of an undisclosed SFFA, the deficiency will be subjected to a 40% penalty. FN36 If the taxpayer underpays tax as a result of fraud, the deficiency will be subject to a 75% penalty. FN37 In addition to the failure-to-file penalty, accuracy-related penalty, and fraud penalty, criminal penalties also may apply for failure to file Form 8938, failure to report an asset, or underpayment of tax. FN38

Statute of limitations. If a taxpayer omits more than $5,000 of income attributable to one or more assets required to be reported under Section 6038D , the IRS will have six years from the date Form 8938 is filed to audit the taxpayer. FN39 Even if there is no omission of income attributable to an SFFA, the three-year statute of limitations is tolled until the form is filed.FN40

FBAR

Taxpayers and practitioners alike should note that the FATCA reporting requirement set forth in Section 6038D is much broader than the FBAR, so it is possible that individuals who do not have an FBAR filing obligation may be subject to the FATCA reporting requirement. For example, the FATCA reporting requires taxpayers with investments in foreign entities, such as foreign hedge funds and private equity funds, to report the existence of these investments. The FBAR regulations issued by FinCEN on 2/26/10 exempt these assets from FBAR reporting. FN41 Nevertheless, many taxpayers may find that they must file both an FBAR and Form 8938; see Exhibit 2.

Exhibit 2a.

Exhibit 2b.

The FBAR generally is required to be filed by a U.S. person with a financial interest, signature authority, or other authority over foreign financial accounts if at any point during the calendar year the aggregate value of all such foreign accounts exceeded $10,000, even if for one day. By contrast, Section 6038D disclosure is required to report SFFAs when the aggregate value exceeds $50,000 "(or such higher dollar amount as the Secretary may prescribe)."

For practitioners who question why there are duplicative filings, the answer lies in the source of the filing obligation. The FBAR is mandated by Title 31, whereas the FATCA filing is mandated by Title 26. Title 31 is titled "Money and Finance," and the purpose of the FBAR as stated in section 5311 is "to require certain reports or records where they have a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings, or in the conduct of intelligence or counterintelligence activities, including analysis, to protect against international terrorism." As such, the information contained in FBARs is not confidential, and federal officials are able to access the computer database in which FBAR information is entered. The information on Form 8938, however, will be subject to the same confidentiality rules in Section 6103 governing tax returns.

CONCLUSION

In an effort to help spur the economy, President Obama has initiated several efforts to generate jobs. One such effort, the "We Can't Wait" campaign, brought the President to Disney World on 1/19/12 where he proclaimed "America is open for business." FN42 He went
on to announce that his Administration was launching a national initiative to attract more foreign travelers to boost tourism and, in turn, jobs.

This was not the Administration's only attempt to attract foreign dollars. For example, on 8/2/11, Alejandro Mayorkas, chief of U.S. Citizenship and Immigration Services, a unit of the Department of Homeland Security, announced initiatives designed to attract and retain foreign entrepreneurs. FN43 In an effort to attract and retain such entrepreneurs, the plan is to make it easier for these desired foreigners to obtain work visas and qualify for permanent residence.

One might wonder if the Administration will provide the foreigners it's recruiting with a summary of the U.S. tax rules and the ever-expanding number of information returns that must be filed. After all, domestic tax preparers and taxpayers have enough trouble staying abreast of the latest tax developments. Since permanent residents can be deported for tax violations, FN44 and taxpayers failing to file informational forms are subject to strict liability penalties, it would be kind of the government to provide these highly sought after foreign recruits with a blueprint of common traps.

Because this is the first year that Form 8938 is required to be filed by taxpayers, one would hope that the IRS will abate any penalties for mistakes associated with filing the form. While there is nothing illegal or improper about holding foreign accounts and assets, the government continues to increase the level of transparency and compliance required by those holding such assets. The penalties for failing to comply are costly. Even though the monetary cost of not complying with the Form 8938 requirements is far less severe than the FBAR requirement, the ancillary penalties are no mere slap on the wrist. The statute of limitations will not begin to run until the form is filed, there is a six-year statute of limitations if $5,000 of income associated with an SFFA is omitted, and a 40% deficiency penalty associated with unreported income from an SFFA.

Practice Notes

Because the penalties can be severe and the reporting obligation is new with this filing season, practitioners must be careful to ensure that taxpayers owning specified foreign financial assets comply with Section 6038D . There has been no indication from the Service
that it might abate penalties for the first year that Form 8938 is due.

FN1 Section 511 of the Hiring Incentives to Restore Employment (HIRE) Act, P.L. 111-147, 3/18/10.

FN2 Section 1298(f). Practitioners should be on the lookout for a revised Form 8621. Under previous law, PFICs needed to be disclosed only when taxpayers made a qualifying elective fund election, received certain distributions from the PFIC, or disposed of their interest in the PFIC.

FN3 Available at www.irs.gov/businesses/corporations/article/0,,id=255061,00.html.

FN4 See Reg. 301.7701(b)-1(c) : "An individual satisfies this test if he or she has been present in the United States on at least 183 days during a three year period that includes the current year."

FN5 Temp. Reg. 1.6038D-1T(a)(5) defines "U.S. possession" to include American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, and the U.S. Virgin Islands. See Packman and Weinstein, "Establishing Residency in the U.S. Virgin Islands--A Look at Section 937's Reach," 105 JTAX 33 (July 2006) , for rules explaining bona fide residency in the U.S. Virgin Islands.

FN6 Reg. 301.7701(b)-2 (among other requirements, "the individual has a closer connection during the current year to a single foreign country in which he or she maintains a tax home than to the United States").

FN7 Temp. Reg. 1.6038D-2T(a)(7)(i).

FN8 Temp. Reg. 1.6038D-2T(b)(2).

FN9 Temp. Reg. 1.6038D-2T(b)(3).

FN10 Id.

FN11 Temp. Reg. 1.6038D-2T(a)(1).

FN12 Temp. Reg. 1.6038D-2T(a)(2).

FN13 Temp. Reg. 1.6038D-2T(a)(3).

FN14 Temp. Reg. 1.6038D-2T(a)(4).

FN15 Temp. Reg. 1.6038D-2T(c)(1)(ii).

FN16 Temp. Reg. 1.6038D-2T(c)(2)(ii).

FN17 Temp. Reg. 1.6038D-2T(c)(2)(i).

FN18 Id.

FN19 Temp. Reg. 1.6038D-2T(c)(1)(i).

FN20 Temp. Reg. 1.6038D-3T(a)(2).

FN21 Temp. Reg. 1.6038D-7T(c).

FN22 Temp. Reg. 1.6038D-3T(a)(3)(i).

FN23 A U.S. person is defined in Section 7701(a)(30) .

FN24 Temp. Reg. 1.6038D-3T(b)(5)(ii).

FN25 Temp. Reg. 1.6038D-3T(b)(5)(i). -3T(b)(5)(i).

FN26 Temp. Reg. 1.6038D-3T(c).

FN27 Temp. Reg. 1.6038D-7T(a)(1) (Form 3520, "Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain
Foreign Gifts"; Form 3520A, "Annual Information Return of Foreign Trust With a U.S. Owner"; Form 5471, "Information Return of U.S.
Persons With Respect to Certain Foreign Corporations"; Form 8621, "Return by a Shareholder of a Passive Foreign Investment
Company or Qualified Electing Fund"; Form 8865, "Return of U.S. Persons With Respect to Certain Foreign Partnerships"; and Form
8891, "U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans").

FN28 Temp. Reg. 1.6038D-3T(a)(3)(ii).

FN29 Temp. Reg. 1.6038D-5T(d).

FN30 Temp. Reg. 1.6038D-5T(f)(1).

FN31 Temp. Reg. 1.6038D-5T(f)(2)(i).

FN32 Temp. Reg. 1.6038D-5T(f)(3)(i).

FN33 Temp. Reg. 1.6038D-8T(e)(2).

FN34 Temp. Reg. 1.6038D-8T(e)(3).

FN35 Temp. Reg. 1.6038D-8T(b).

FN36 Temp. Reg. 1.6038D-8T(f) and Section 6662(j) .

FN37 See the Form 8938 instructions.

FN38 Temp. Reg. 1.6038D-8T(f)(2).

FN39 Section 6501(e)(1)(A)(ii).

FN40 Section 6501(c)(8)(A).

FN41 See Packman, "Reporting Foreign Accounts: Treasury Applies the Carrot and the Stick," 112 JTAX 334 (June 2010) .

FN42 See www.nationaljournal.com/whitehouse/quick-take-in-disney-world-obama-looks-to-boost-tourism-create-jobs-20120119.

FN43 See online.wsj.com/article/SB10001424053111904292504576482573203358158.html.

FN44 See Kawashima v. Holder, 132 S.Ct. 1166 (3/21/12).

© 2012 Thomson Reuters/RIA. All rights reserved.

Premarital Agreements and the Business Owner

Wed, 19 Dec 2012 09:00:14 +0000

Premarital Agreements and the Business Owner

By Linda J. Ravdin

Some people planning to marry want to enter into a premarital agreement. A business owner may have particular concerns that may cause him or her to consider a premarital agreement. There are a variety of issues the lawyer for the business owner needs to pay special attention to.

Why a business owner may seek a premarital agreement.

A business owner may want a premarital agreement to protect his or her exclusive rights to the business if the marriage fails, and to control the disposition of the business after his or her death. At divorce, whether appreciation in the value of a premarital business is marital property can become the subject of an expensive court fight. Similarly, the value of the good will of a business can be disputed, with competing expert witnesses and substantial risk for the owner. A premarital agreement can take the business out of the pool of assets that may be divided at divorce. It can also allow the owner to pass the business on to a child from a prior marriage at his or her death free of a spousal claim.

Criteria for validity.

The standards for validity of a premarital agreement are the same for a business owner as for anyone else. The agreement must be executed voluntarily, not as a result of duress. Parties should make a fair financial disclosure. However, they can waive disclosure so long as the waiver is voluntary.

A premarital agreement need not be fair. However, a spouse who is entitled to very little at the end of a marriage has an incentive to challenge validity. Even when the proponent wins, in the reported cases, the winning proponent had to pay for a trial and at least one appeal. We don't know about the cases that settled out of court because the process was flawed and the proponent did not want the risk or expense of a trial. Moreover, in those cases where the proponent won, he or she may have been forced to grant access to business records in discovery, something the agreement may have been designed to avert.

Best practices.

When there is a disparity in resources at the outset, and even when parties are

in comparable circumstances, it is in the interest of the business owner to follow best practices in the negotiations leading to the signing of a premarital agreement. These include:

Timing. The proponent should present the proposed agreement to his or her fiancé(e) well before the wedding. How long depends on many factors. Better still is presenting the proposed agreement before setting a date for the wedding.

Actual negotiation. Courts have recognized that an actual negotiation is a transaction between equals which equates to a voluntary agreement. The stronger party should be open to considering proposed changes and should agree to some.

Access to counsel. When both parties are represented by counsel, it is almost impossible to get a court to throw out a premarital agreement. When there is a significant disparity in resources, the stronger party should consider paying the weaker party's legal fees. Doing so furthers the stronger party's interest in validity.

Financial disclosure. A good financial disclosure, so that a weaker party knows what he or she is giving up claims to, is an important key to validity.

Substantive fairness. The laws of Virginia, Maryland and the district of Columbia (and the majority of other states) permit premarital agreements that are very unfair to an economically weaker party so long as the process of getting the agreement was fair. However, when there is a big disparity in resources, the stronger party is usually better served by an agreement that makes adequate provisions for the financial security of his or her future spouse.

Disclosure issues of special concern to the business owner.

Disclosure of the value of an interest in a closely held business or professional services practice presents a special challenge. The value may not be readily ascertainable, the owner may be reluctant to disclose information that could be of interest to competitors, or the owner's partners may not wish to have such information shared.

It is a mistake for the owner to assume that the other party's knowledge of the existence of the business is tantamount to an understanding of its value.

The gold standard for a disclosure in connection with a premarital agreement is a written statement appended to the agreement identifying all significant assets and providing a reasonable statement of values. However, a business owner may want to consider other options, such as:

A statement of net worth without a breakdown.
A detailed statement of nonbusiness assets and their values coupled with a different sort of disclosure for the business.

The problem of stating the value of a closely held business.

There are several challenges in creating a financial disclosure for a business owner that will stand up against attack. The value may not be readily ascertainable. Yet a statement that understates value or is misleading or incomplete puts the validity of the agreement at risk. There is no obligation to engage an expert appraiser to appraise a business for purposes of a premarital agreement. In the absence of a formal appraisal, the owner, and his or her lawyer, should take precautions in the disclosure of value. There are various standards of value, including book value and fair market value. The owner may use book value, but should qualify the statement if he or she does so. For example, in a 1984 Maryland case, Head v. Head, the husband stated the value of his business, the company that made the Prince tennis racket, at book value, but qualified the statement by saying actual value could be much higher. The appeals court held the agreement was valid even after the husband sold the company for 17 times book.

Another approach to disclosing the value of a business is for the owner to provide known data - e.g., gross revenues for a three-period; the amount the owner took out in compensation over the same three-year period; a balance sheet; a profit and loss statement; the business tax return or the Schedule C for a sole proprietorship; a narrative statement of the history of the business, what it sells, who founded it, how long it has been in operation, and other background facts that can help the weaker party understand what he or she is giving up a claim to. Courts have upheld premarital agreements that have taken this approach to disclosure.

The lawyer for the business owner should make some inquiries to make sure that there are no problems relating to disclosure lurking in the background, including:

Does the business have key person insurance and, if so, what is the amount of the death benefit? The owner's statement of value should not contradict any statement of value made to the insurance company, or should be explained.

Has the owner made a statement of his/her opinion of value, e.g., in an application for life insurance, a loan application, or in another place where criminal penalties may apply? A disclosure for a premarital agreement should not contradict such a statement, or should explain the discrepancy.

Has the business been valued recently for the client's divorce, or for a divorce of one of the other owners of the business, or in connection with a probate of the estate of a deceased owner? If the valuation is fairly recent, the lawyer should get a copy of the valuation report. If the disclosure for the premarital agreement contradicts that opinion, the disclosure statement may need to include an explanation of the difference.

Terms to protect the owner.

There are several terms that a premarital agreement drafted on behalf of the business owner should generally include:

The interest in the business should be defined as the owner's separate property, meaning he or she will have exclusive rights to it at death or divorce. The agreement may include some compensating provisions for the other spouse, discussed below.

The agreement should include explicit text that defines all appreciation, whether the result of active efforts of either spouse or passive market forces, as part of the owner's separate property in the event of separation/divorce.

If a non-owner spouse will work for the owner, the owner should have a separate employment agreement with the spouse-employee.

Terms to provide for a weaker party.

A business owner who wishes to include provisions in a premarital agreement for his or her spouse has a variety of options available, limited only by the creativity of the parties and their willingness to compromise. Parties may wish to consider terms that would take effect at divorce or after a death as well as obligations during the marriage, or a combination. Some options include:

An owner could agree to transfer an existing home into joint names, or to acquire a jointly titled home.

The business owner spouse may agree to make cash gifts to the other spouse upon marriage or over time during the marriage to allow him or her to create a nest egg.

The business owner may agree to pay all living expenses, educate the spouse's children, or assume other obligations that may allow that party to save and invest his or her own resources. This could also include an obligation to maintain long-term care insurance for a spouse to provide for his/her future healthcare needs.

The owner may agree to a cash payment as a property settlement or the transfer of specified assets, such as real estate or securities, in the event of divorce. The amount can be tied to the length of the marriage.

The agreement can reserve the weaker party's right to seek an alimony award, or can provide for a specified amount and duration of alimony at divorce.

The agreement can provide for a surviving spouse at death through a trust, life insurance, a cash bequest, survivor benefits under a retirement plan, or the right to certain assets that will be held in a survivorship form (such as a jointly owned home).

Confidentiality issues.

A business owner may be particularly sensitive to disclosures made in connection with the execution of a premarital agreement being disseminated to others, such as family members of the spouse, as well as private information and documents becoming public in the event of a future dispute. As part of the process leading to execution, the owner must strike the right balance between providing sufficient data, and doing so in a way that can be readily provable in the event of a challenge, especially one that occurs after the client's death, and the owner's interest in keeping business information private. One option is for the owner to make a variety of documents available for review by the fiancé(e) and his/her lawyer, but not to allow these documents to be copied. The agreement should identify with specificity which documents were made available. There are a variety of other ways this process can be conducted, depending upon the particular circumstances.

The agreement can include a confidentiality provision that requires the parties to maintain the financial disclosures in confidence. This would preclude a party from giving copies of the other party's disclosure to his or her adult children or friends, but would allow him or her to show it to his/her own lawyer, accountant, or financial advisor.

The confidentiality clause could also include terms governing future litigation, such as a requirement that business documents be submitted to a court under seal.

Another way to limit dissemination of sensitive business information in the future is through a form of alternative dispute resolution that keeps the parties out of court and their financial records out of the public record.

Dispute resolution.

Even when there is no dispute about validity of a premarital agreement, parties may disagree about the meaning of some of the terms, or there may be matters deliberately left for future resolution, such as the specifics of a division of property at divorce. Parties may wish to provide for alternative dispute resolution to keep the dispute out of court and out of the public record.

The agreement could provide that a CPA or other trusted advisor would assist the parties to divide up any property that the agreement provides is to be shared at divorce, and to advise about the tax consequences of the division.

Appraisal. It is common for a premarital agreement to provide for appraisal of property subject to the agreement where the value is in dispute.

The agreement could provide for binding arbitration of any dispute about the meaning of the agreement or the parties' rights and obligations under it. Such a provision can be very useful also to resolve a claim of breach or an issue deliberately left open, such as an alimony claim. However, an agreement should not provide for binding arbitration of a dispute about validity. decisions of an arbitrator are virtually unappealable. A party who may be disadvantaged by a wrong decision on validity should retain the right to appeal that decision.

Great Lakes Gold Rush: Valuing Mineral Rights in the Utica and Marcellus Shale Plays

Tue, 18 Dec 2012 20:49:27 +0000

Great Lakes Gold Rush: Valuing Mineral Rights in the Utica and Marcellus Shale Plays

By: Robert A. Hauptmann and Patrick M. Polomsky

Eager to stake their claims, prospectors flocked in droves hopeful that great wealth could be achieved from extracting the regions' valuable natural resources. The region described is not Northern California in 1849, but New York, Ohio, Pennsylvania, and West Virginia in the present day. The resource is not gold, but natural gas that can now be profitably extracted from the Marcellus and Utica shale plays. And, unlike the California Gold Rush, it is not only the prospectors, supply merchants, and saloonkeepers who will become rich. Landowners holding tracts of what was previously undeveloped or agricultural land in Ohio, Pennsylvania, and surrounding states are the serendipitous beneficiaries of the Great Lakes Gold Rush in the form of upfront bonus payments and subsequent royalties from oil and gas companies leasing the shale gas rights to their land. The wealth created through leasing these shale rights is often not planned for, yet the dollars involved can be significant. The speculative nature of drilling for gas and oil presents challenges in valuing these rights, but also opportunities for gift tax planning.

Shale Gas Overview

Shale gas refers to natural gas and oil trapped inside shale rock formations. Minuscule pores in the shale often hold significant amounts of natural gas that are difficult to recover using traditional vertical drilling methods. Shale gas production can involve multiple hydrocarbons ranging from dry gas, which is predominately methane commonly used in heating homes, cooking, and generating electricity, to wet gas which also contains concentrations of natural gas liquids (propane, butane, and ethane), to crude oil. The natural gas liquids or NGLs must be removed before the natural gas is transported via pipeline. Notable U.S. shale gas plays include Bakken (North Dakota and Montana), Barnett and Haynesville (Texas and Louisiana), and the Marcellus and Utica plays (New York, Ohio, Pennsylvania, and West Virginia). It has been known for some time that these aforementioned domestic shale plays represent large reserves of natural gas and other resources, but until recently it was thought to be uneconomical to recover these resources.

The first U.S. natural gas well was drilled in New York State in the early 1800s, but little gas was produced due to the density of the shale. Whereas vertical wells can draw from an oil reservoir from a single access point, these wells are less effective in extracting shale gas FN1. The possibility for large-scale shale gas production was first seen during the 1970s when the Department of Energy and private companies partnered to develop techniques for commercial production of natural gas in the Devonian shale play. Techniques for horizontal drilling and hydraulic fracturing developed from this partnership. Mitchell Energy and Development Corporation experimented with hydraulic fracturing in the Barnett shale in the 1980s and '90s, which helped make large-scale shale gas production a commercial reality FN2. When used in combination, horizontal drilling and hydraulic fracturing ("fracking") "create artificial porosity and permeability within the rock", changing previously undeveloped land into hotspots for natural gas and oil production FN3. Fracking involves pumping water and liquids into wells under high pressure to fracture the shale rock to open pores and release trapped gas and oil. After the shale has been fractured, sand and other elements in the pumping fluid hold open the newly fractured pore space, which allows the natural gas to flow into the well FN4. Developments in horizontal wells allow drillers to drill down to the level of the shale and turn a well 90 degrees horizontally through the shale rock FN5. Horizontal drilling increases the productivity of any single vertical well by up to 10 times. However, horizontal wells cost between $6 million and $8 million to drill as compared to approximately $1 million for a vertical well FN6. Due to these recent technological advances, shale plays, such as the Utica and Marcellus, are now seen as an economical source for natural gas and oil. The Haynesville shale play produced only a negligible amount of natural gas in 2008, but now accounts for 8% of total U.S. natural gas output FN7.

According to the U.S. Energy Information Administration ("EIA"), "shale gas's portion of U.S. natural gas production has climbed from less than 2% in 2001 to nearly 30% today and EIA projects it will reach 49% by 2035," or from approximately 5.0 trillion cubic feet today to 13.6 trillion cubic feet in 2035 FN8,9. For reference, one trillion cubic feet of natural gas represents enough supply to heat 15 million homes for one year FN10. Marianne Kah, chief economist for ConocoPhillips, referred to the recent shale boom as the "most significant change in the energy industry since the 1940s" FN11. Largely due to the shale gas plays, the Congressional Research Service now claims that the United States "has the world's largest fossil-fuel resources - greater than Saudi Arabia, Canada and China combined."FN12

Utica and Marcellus Shale Plays

Over the past several years, significant investments have been made in pursuit of natural gas and oil from the Marcellus and Utica shale plays. The Utica shale play is more geographically extensive than Marcellus, underlying portions of New York, Ohio, Pennsylvania, West Virginia, and Virginia. The Marcellus shale is concentrated in New York, Pennsylvania, and West Virginia. Due to its shallower depth, the Marcellus has experienced more development activity to date with more than 5,000 wells being drilled in Pennsylvania alone since 2005 FN13. Economists at Penn State University estimate that Marcellus shale gas drilling and production contributed $11.2 billion to the Pennsylvania economy in 2010 FN14. The success of the Marcellus shale play has led investors to expect similar results from the Utica shale in Ohio. Although the Marcellus may also temporarily be a victim of its own success as the incremental supply of natural gas from Marcellus shale has contributed to the decline of natural gas prices and the refocusing of efforts on more profitable wet gas regions. The higher profit potential from the NGL and oil rich regions of the Utica shale is expected to encourage investment in Utica development at a rate greater than that of the Marcellus FN15. Chesapeake Energy alone has invested billions of dollars to acquire nearly 1.3 million net acres in the Utica shale FN16. Industry reports predict "that growth in Ohio's oil and natural gas production could lead to 200,000 new jobs and $14 billion in investments in the next four years." FN17

The Utica shale is located several thousand feet below the Marcellus shale and has the potential to be an enormous resource for natural gas. "The Ohio Department of Natural Resources ("ODNR") estimates a recoverable Utica shale potential between 1.3 and 5.5 billion barrels of oil and between 3.8 and 15.7 trillion cubic feet of natural gas." FN18 While over 5,000 wells have been drilled in the Marcellus since 2005, Ohio's shale gas industry is still in its early stages. Land is still being leased, permits are being acquired, and drilling has only just begun in a few counties, but activity is rapidly increasing. 100 permits for horizontal wells were issued by the State of Ohio in 2011, up from 5 in the prior year. Through May 2012, an additional 121 permits were issued and by 2014 the number of producing wells is estimated to be around 1,000 FN19.

Much of the recent focus of the news media has been on the record number of signings of shale gas leases as oil and gas companies jockey to lock up the more valuable drilling sites. Shale gas leases are negotiated directly with individual landowners, so lease terms vary, but most leases include an upfront bonus payment or "spud fee," an ongoing royalty payment based on the gas and other resources recovered from the landowner's property, and delay payments. Delay payments refer to annual payments made to the lessor prior to a well being drilled FN20. Leases can be structured as either developmental, which provides the lessee access to the surface for drilling and well operation, or non-developmental, which only provides the lessee with the rights to the subsurface minerals FN21. Leases should specify the extent of the mineral estate interest and if water rights are included. The lease period is often split into a primary and a secondary term. The primary term refers to the exploratory period before drilling occurs, which may extend for up to two years. The secondary term refers to the length of the lease after drilling begins and extends for as long as certain production levels are met. Additional points commonly outlined in a shale gas lease include mandatory pooling of surrounding parcels of land; the site of a well, access roads, and pipelines on the landowners' property; the storage of gas, water, and brine; free gas available for the landowner's use; lease termination; and the steps involved in restoring the land post-drilling FN22.

Valuation of Shale Gas Rights

The value of an intangible asset such as shale gas rights is a function of the expected future income generated by the rights. A form of the Income Approach, typically the Discounted Cash Flow Method, is the methodology most often used in valuing shale gas rights. Applying this methodology involves projecting the anticipated royalty income and any expenses associated with the shale gas rights and discounting the cash flows back to a specific valuation date at an appropriate rate of return.

Projecting future cash flows from wells extending thousands of feet below the surface is a challenging exercise. Well production can range from one to two million cubic feet of natural gas per day to as much as twenty million cubic feet per day for the most productive wells FN23. Because the natural gas and any related liquids (e.g., NGLs, crude oil, etc.) are trapped inside shale rock, it is difficult to predict when and how much gas or other resources will be recovered. The key variables influencing the projections, including timing, production, and pricing, can be supported by analyzing published data on comparable wells and through due diligence conversations with the landowner.

Timing: Projecting the timing of a well's cash flows depends upon the stage in its life cycle. If a lease is not in place, then the timing to negotiate a signed lease and the corresponding upfront cash bonus payment should be factored into the projection. Significant time may pass between the signing of a lease and the actual drilling of a well. Areas in which significant production is anticipated or where wet gas is thought to be present will be the initial focus of drillers. Areas outlying the epicenters of drilling activity or that contain only dry gas may not experience activity for years after a lease is signed or at all until the price of natural gas rises. On average, a shale gas well takes about two months to drill and up to an additional six months for the post-production infrastructure to be put in place FN24.

Production: The amount of gas or oil extracted from a well is location-specific and is particularly difficult for geologists to estimate in pre-production shale plays. It is important to rely on production data from wells in similar geographies or that are otherwise analogous when developing production assumptions. The type and quantity of oil and gas differs by shale play and even within the same region. The Utica shale play is relatively new in terms of the number of wells being drilled, so limited production data is available. Based on 2011 production data released by Chesapeake Energy, the company has drilled a total of 59 wells in the Utica shale. Nine of these wells are producing and all but one well are located in wet gas areas FN25. Chesapeake's largest producing well in the Utica is the Buell 8H Well, which is located in Harrison County, Ohio. The Buell 8H Well produced approximately 1.52 billion cubic feet of gas and 13,500 barrels of oil equivalent over 198 days, which is approximately 2% of total gas production in the entire state of Ohio FN26. Experience in more mature shale plays has proven that the first few years of a well are the most productive and the highest production is concentrated in the first few months. "Approximately 25% of a shale gas well's gas production emerges in the first year and 50% within four years. Thereafter, the output falls very slowly and wells are expected to continue supplying gas for about 30 to 50 years." FN27

Pricing: Those who have paid a gas bill over the last several years are familiar with the recent pricing fluctuations of natural gas. Between May 2008 and May 2012, natural gas prices declined from a high of approximately $13 per thousand cubic feet ("Mcf") to $2 per Mcf FN28. Depressed natural gas prices are slowing drilling and production activity in dry gas shale plays in favor of the more profitable wet gas plays or in areas where oil is also present. The decline in natural gas prices is projected to reverse over the next several years, which should boost production in dry gas regions and drive the drilling of additional wells. Respondents to Grant Thornton's Annual Energy Survey expect the spot price of natural gas to increase to approximately $3.91 per Mcf in 2012, $4.30 per Mcf in 2013, and $4.69 per Mcf in 2014 FN29. The New York Mercantile Exchange ("NYMEX") forward pricing curve suggests similar increases in natural gas prices.

The upfront cash bonus payment and the negotiated royalty rate on the gas produced are additional variables that need to be factored into the analysis. Bonus payments often range from $1,000 to $5,000 per acre and royalty rates can range from 12% to 20% depending on location. Once the cash flow forecast is developed, it should be present-valued at a rate of return that reflects the risks associated with achieving the cash flows. The appropriate rate of return will vary based on the stage of production of the well. Shale gas rights on land where drilling is complete and production has begun are inherently less risky and therefore more valuable than rights to land where drilling has not begun and no lease is in place. The applicable discount rate should also incorporate the risk associated with fluctuations in natural gas prices, the potential for variances in well output, and the risk of any associated environmental liabilities.

Conclusion

Through detailed analysis of data from comparable wells and observations of more mature shale plays, reasoned and supportable valuations of Utica and Marcellus shale gas rights can be developed. For owners of land where productive wells are drilled, significant wealth can be created virtually overnight. But any Fair Market Value analysis of pre-production shale gas rights must also factor in the risk that this asset could ultimately have little or no value. Even if a shale gas lease is in place, it is possible that drilling may be delayed for years or may never happen at all. Wells may be less productive than predicted. Natural gas prices may remain depressed, resulting in lower than expected royalty payments and additional delays in drilling new wells. This risk profile means that the Fair Market Value of pre-production shale gas rights will be highly discounted relative to the post-production rights of the well. The potential for substantial appreciation and income generation make shale gas rights an ideal asset for gift tax planning.

Gift and estate tax planning works best with an asset that has the potential to significantly increase in value after it is transferred to a donee. With a stagnant stock market and troubled real estate industry, many traditional assets that were staples in gift tax planning are no longer assets viewed as possessing the potential for significant value increases in the hands of the donee. However, shale gas royalty lease rights represent the type of asset that can be an estate and gift homerun. A pre-production shale gas right is an uncertain asset with a boom or bust potential outcome. Because of the bust prospect, the current Fair Market Value is constrained. However, if the future well is successful, a high value asset exists for the donee and the substantial appreciation occurs outside the donor's estate. For landowners in the Utica and Marcellus shale, the Great Lakes Gold Rush may represent a once-in-a-generation opportunity to transfer wealth to the next generation at a low gift Fair Market Value.

Robert A. Hauptman, CFA is a Director in the Valuation & Financial Opinions Group at Stout Risius Ross (SRR). He has provided business valuation and financial advisory services for numerous purposes, including estate and gift taxation, corporate acquisitions and divestitures, buy-sell agreements, shareholder disputes and marital dissolution, issuance of equity compensation and stock options, corporate and strategic planning, determination of merger-exchange ratios, among others. Mr. Hauptman can be reached at +1.216.373.2997 or rhauptman@srr.com.

________________________________

Footnotes:

1 Moseman, Andrew. "U.S. Natural Gas Boom: The Race to Tap Shale's Potential" 18 December 2009 .

2 "Review of Emerging Resources: U.S. Shale Gas and Shale Oil Plays" U.S. Energy

Information Administration. July 2011, page 4.

3 King, Hobart. "Shale" .

4 King, Hobart. "Hydraulic Fracturing of Oil & Gas Wells Drilled in Shale" .

5 King, Hobart. "Shale" .

6 "Vertical vs. Horizontal Drilling - Differences" .

7 Secretary of Energy Advisory Board. "Shale Gas Production Subcommittee 90-Day Report"

U.S. Department of Energy. 18 August 2011.

8 "Annual Energy Outlook 2012 Early Release Overview" U.S. Energy Information Administration.

9 Williams, Susan. "Discovering Shale Gas: An Investor Guide to Hydraulic Fracturing" IRRC Institute. February 2012, page 8.

10 "Producing Natural Gas From Shale" U.S. Department of Energy. 26 January 2012. .

11 Schoenberger, Robert. "Cheap Energy From Shale Gas May Fuel Manufacturing Boom, Economists Say." The Cleveland Plain Dealer 1 June 2012; pages C1 - C2.

12 Ridley, Matt. "The Shale Gas Shock" The Global Warming Policy Foundation. 2011.

13 "More Than 5,000 Marcellus Wells Drilled Since 2005" The Business Journal. Youngstown,

Ohio, 7 May 2012.

14 Hunt, Spencer. "Fracking Future: Controversial Method of Extracting Fuel from Shale Expanding in Ohio". The Columbus Dispatch 25 September 2011.

15 Ohio Shale Coalition. "An Analysis of the Economic Potential for Shale Formations in Ohio", page 26.

16 "Chesapeake Reports New Utica Production Volumes" The Business Journal. Youngstown, Ohio, 2 May 2012.

17 Hunt, Spencer. "Fracking Future: Controversial Method of Extracting Fuel from Shale Expanding in Ohio". The Columbus Dispatch 25 September 2011.

18 King, Hobart. "Utica Shale - The Natural Gas Giant Below the Marcellus?"

19 Smith, Robert L. "Northeast Ohio's Economy Could Get Boost It Needs from Gas Drilling" 21 May 2012.

20 Ohio Department of Natural Resources. "Landowners and Leasing for Oil and Gas in Ohio"

21 Ohio Department of Natural Resources. "Oil and Gas Leasing in Ohio"

22 Ohio Shale Coalition. "Shale Gas Development in Ohio: Landowner Leasing". Powerpoint presentation.

23 King, Hobart. "Production Decline of a Natural Gas Well Over Time"

24 Ohio Shale Coalition. "An Analysis of the Economic Potential for Shale Formations in Ohio", page 15.

25 "Chesapeake Reports New Utica Production Volumes" The Business Journal. Youngstown, Ohio, 2 May 2012.

26 "Statehouse Report" County Commissioners Association of Ohio. 6 April, 2012.

27 Ridley, Matt. "The Shale Gas Shock" The Global Warming Policy Foundation. 2011.

28 U.S. Energy Information Administration: Independent Statistics and Analysis. "Natural

Gas"

29 Grant Thornton LLP. "The State of the Industry - An Engine for U.S. Growth" Survey of Upstream U.S. Energy Companies 2012.

The Financial Danger of Maximizing Taxable Gifts in 2012

Tue, 27 Nov 2012 16:27:15 +0000

The Financial Danger of Maximizing Taxable Gifts in 2012

By: Jerome M. Hesch (FN1)

At present, clients and their estate planning advisors are contemplating making $5,120,000 taxable gifts (or twice that amount using the split gift election) before year-end because the gift tax exemption may revert to $1,000,000 (FN2) starting in 2013. Before making the maximum taxable gifts for the remainder of the 2012 year, clients need to be made aware of the possibility that maximizing their taxable gifts can cause a financial hardship if the gifts are made to grantor trusts. Before making such gifts, clients and their advisors need to take into account the financial impact caused by the grantor having to pay the income taxes on the grantor trust's taxable income and take precautionary steps if those projections show that the income tax treatment will not leave the grantor with sufficient assets for support in their later years.

This article is designed to show that for individuals with a life expectancy of over 20 years, making the maximum taxable gifts may not be the optimal strategy. In evaluating whether to take advantage of the $5,120,000 gift tax exemption for the rest of the 2012 year, one needs to take into account the ages of the clients, their living expenses and the amount of their income-producing assets. The situation illustrated below shows that for a couple ages 62 and 59 with $46,000,000 of investment assets, they should not make the maximum $10,240,000 in taxable gifts to a grantor trust.

Although the primary objective of an outright gift in trust is to shift future income and future appreciation in value to the trust without any gift taxes, a separate wealth shifting benefit arises by the grantor's payment of the grantor trust's Federal and state income tax liabilities relating to the trust's taxable income (referred to as the "burn"). Over a long period of time, the transfer tax-free shifting of value from grantor trust status has a far greater impact than valuation discounts and the shifting of future income and future appreciation in value combined.

When there is a transfer to an irrevocable trust, and the trust is treated as a grantor trust for Federal income tax purposes, the Internal Revenue Code creates a fiction in that the individual who creates the trust (referred to as the "grantor") is deemed to own the trust's assets, and, as the deemed owner of the trust's assets, the grantor must report the trust's income on the grantor's individual income tax return even though the grantor does not receive a distribution of that income, such as when the income is accumulated or distributed to a trust beneficiary. Accordingly, the grantor must pay the income taxes on the trust's income at the grantor's individual income tax rates. The Internal Revenue Service ruled that the grantor's payment of the income taxes on the grantor trust's income is not a gift for gift tax purposes (FN3).

Suppose a grantor trust received a taxable gift of $5,000,000, with no gift taxes because the first $5,000,000 of taxable gifts is not subject to gift taxes, and the contributed asset generates $250,000 of ordinary income annually. If the combined state and Federal income tax on this income is $100,000 (a combined Federal and state effective income tax rate of 40%), the grantor is required to pay the income taxes on the trust's income. In effect, the grantor has effectively made a gift-tax free transfer of another $100,000. And, this indirect tax-free gift continues each year that the grantor is living and paying the income taxes on the grantor trust's income. Over a long period of time, the amount of wealth that can be shifted as the principal in the trust continues to grow can deplete far more wealth than was intended at the time the grantor trust was funded.

The following example illustrates the burn caused by the grantor's payment of the Federal and state income taxes on the trust's taxable income. The illustration demonstrates that for a couple ages 62 and 59 with $46,000,000 of investment assets, over a long period of time the burn can deplete far too much from their retained investment assets and leave the grantor with little or no assets if the grantor lives too long. Given their young age from an estate planning perspective, it may be advisable that this couple not make the maximum $10,000,000 of taxable gifts during the 2012 year.

Example Mr. & Mrs. Senior are ages 62 and 59. Although their joint life expectancy under Table 2000CM is 26 years, there is a 50% probability that at least one of them will be living some 26 years from now. Given that they have access to better heath care, it is reasonable to expect that one of them will live to age 95. Therefore, any financial projection needs to illustrate the impact of the "burn" caused by grantor trust status for the next 36 years for an individual currently age 59. As residents of New York State, the impact of state income taxes needs to be taken into account. Their living expenses (other than Federal and state income taxes) need to be considered as those expenditures also deplete their estate. Their current living expenses are $600,000, and they will increase by 1% annually. Their investment assets are $46,000,000 and generate a 5.25% rate of return (all ordinary income) over the 36-year period for the projections. They have been advised to take advantage of the maximum $5,120,000 taxable gifts that can be made before the end of the 2012 year without any gift taxes and decide to make two such gifts. But first, they contribute $13,333,333 of their investment assets to a family limited partnership. After applying a conservative 25% valuation discount, the value of their limited partnership interest is $10,000,000. They then give their discounted limited partnership interests to a grantor trust for the benefit of junior family members. Assume that the grantor trust makes no distributions and reinvests the income each year at the same 5.25% investment rate of return.

The "burn" caused by grantor trust status over a long period of time can deplete such a significant amount in later years that by the time the 36 years expire, there is nothing left in their estate. The following table illustrates the impact of the "burn" caused by the trust receiving the maximum taxable gifts over a long period of time.

Retained Investment Assets After Gifts $32,666,667

Pre-Discounted Value of Gifts $13,333,333

Investment Assets Before Gifts $46,000,000

Pre-discounted Value of Gift ($13,333,333)

Living Costs over 36 years ($25,846,127)

Seniors' Earnings over 36 years $45,651,254

Income Taxes on Seniors' Earnings over 36 years ($21,126,117)

Income Taxes on Trust's Earnings over 36 years ($32,851,376)

Balance in Gross Estate at end of 36 years ($1,505,700)

Year Age of Add: Less: Tax on Less: Tax Less: Living Remaining

Younger Earnings Earnings on Trust Costs Investment

Spouse Earnings Assets After

Gifts Made

$32,666,667

2,012 60 1,715,000 717,728 292,950 600,000 32,770,990

2,013 61 1,720,477 799,162 342,220 606,000 32,744,085

2,014 62 1,719,064 798,505 360,187 612,060 32,692,397

2,015 63 1,716,351 797,245 379,097 618,181 32,614,225

2,016 64 1,712,247 795,339 398,999 624,362 32,507,772

2,017 65 1,706,658 792,743 419,947 630,606 32,371,134

2,018 66 1,699,485 789,411 441,994 636,912 32,202,302

2,019 67 1,690,621 785,293 465,199 643,281 31,999,150

2,020 68 1,679,955 780,339 489,622 649,714 31,759,430

2,021 69 1,667,370 774,493 515,327 656,211 31,480,769

2,022 70 1,652,740 767,698 542,381 662,773 31,160,657

2,023 71 1,635,934 759,892 570,856 669,401 30,796,442

2,024 - 72 1,616,813 751,010 600,826 676,095 30,385,324

2,025 - 73 1,595,230 740,984 632,370 682,856 29,924,344

2,026 - 74 1,571,028 729,743 665,569 689,685 29,410,376

2,027 - 75 1,544,045 717,209 700,512 696,581 28,840,119

2,028 - 76 1,514,106 703,302 737,288 703,547 28,210,087

2,029 - 77 1,481,030 687,938 775,996 710,583 27,516,599

2,030 - 78 1,444,621 671,027 816,736 717,688 26,755,770

2,031 - 79 1,404,678 652,473 859,615 724,865 25,923,495

2,032 - 80 1,360,983 632,177 904,744 732,114 25,015,443

2,033 - 81 1,313,311 610,033 952,243 739,435 24,027,043

2,034 - 82 1,261,420 585,929 1,002,236 746,830 22,953,467

2,035 - 83 1,205,057 559,749 1,054,854 754,298 21,789,624

2,036 - 84 1,143,955 531,367 1,110,233 761,841 20,530,138

2,037 - 85 1,077,832 500,653 1,168,521 769,459 19,169,338

2,038 - 86 1,006,390 467,468 1,229,868 777,154 17,701,238

2,039 - 87 929,315 431,667 1,294,436 784,925 16,119,525

2,040 - 88 846,275 393,095 1,362,394 792,775 14,417,537

2,041 - 89 756,921 351,590 1,433,920 800,702 12,588,246

2,042 - 90 660,883 306,980 1,509,200 808,709 10,624,239

2,043 - 91 557,773 259,085 1,588,433 816,796 8,517,696

2,044 - 92 447,179 207,715 1,671,826 824,964 6,260,370

2,045 - 93 328,669 152,667 1,759,597 833,214 3,843,562

2,046 - 94 201,787 93,730 1,851,976 841,546 1,258,097

2,047 - 95 66,050 30,680 1,949,204 849,962 (1,505,700)

As the assets in the grantor trust continue to grow, the taxable income earned by the grantor trust continues to increase, and the compounding of this growth results in a burn of over a million dollars a year starting when the couple reaches ages 84 and 81 (year 2034, which is some 14 years before the younger spouse reaches age 95). Over the entire 36-year period the combined Federal and state income taxes paid by the grantor on the grantor trust's taxable income is $32,851,376. So, we have achieved the perfect estate plan! By the younger spouse's death at age 95, there is nothing left. Of course, the spouses then ask you "What happens if one of them is still alive in year 2047?"

Grantor Trust

Year Value of Gifts before discounts Taxable Income Balance 2,012 13,333,333 700,000 14,033,333

2,013 - 736,750 14,770,083

2,014 - 775,429 15,545,512

2,015 - 816,139 16,361,652

2,016 - 858,987 17,220,638

2,017 - 904,084 18,124,722

2,018 - 951,548 19,076,270

2,019 - 1,001,504 20,077,774

2,020 - 1,054,083 21,131,857

2,021 - 1,109,423 22,241,280

2,022 - 1,167,667 23,408,947

2,023 - 1,228,970 24,637,917

2,024 - 1,293,491 25,931,407

2,025 - 1,361,399 27,292,806

2,026 - 1,432,872 28,725,678

2,027 - 1,508,098 30,233,776

2,028 - 1,587,273 31,821,050

2,029 - 1,670,605 33,491,655

2,030 - 1,758,312 35,249,967

2,031 - 1,850,623 37,100,590

2,032 - 1,947,781 39,048,371

2,033 - 2,050,039 41,098,410

2,034 - 2,157,667 43,256,077

2,035 - 2,270,944 45,527,021

2,036 - 2,390,169 47,917,190

2,037 - 2,515,652 50,432,842

2,038 - 2,647,724 53,080,566

2,039 - 2,786,730 55,867,296

2,040 - 2,933,033 58,800,329

2,041 - 3,087,017 61,887,346

2,042 - 3,249,086 65,136,432

2,043 - 3,419,663 68,556,095

2,044 - 3,599,195 72,155,290

2,045 - 3,788,153 75,943,442

2,046 - 3,987,031 79,930,473

2,047 - 4,196,350 84,126,823

As the above table illustrates, a $10,000,000 taxable gift to a grantor trust results in $84,126,823 accumulating in the trust free of all transfer taxes!

If a couple with $46,000,000 of investment assets is left with $32,666,667 of investment assets after making two $5 million taxable gifts, it initially appears that the income and principal from their remaining assets will be more than sufficient to provide the funds needed to pay their living expenses and the income taxes on the taxable income generated by their retained assets and the taxable income of the grantor trust. Initially, the income tax on the grantor trust's taxable income (the "burn") is $292,950, and the value of their retained investment assets actually increases for the next few years. As the assets in the grantor trust continue to grow, the burn gradually increases, and a point is reached in year 2033, when the younger spouse is age 81, where their retained assets ($24,027,043) generate taxable income ($1,313,311) that is sufficient to pay only the income taxes ($610,033) on the taxable income from their retained assets and their living expenses ($739,435). At this point, the annual burn has reached $952,243 and will continue to grow each year. Therefore, it may be practical to discontinue grantor trust status at the end of the 2033 year.

The above example assumed an investment rate of return of 5.25% so that the full depletion of their investment assets did not occur until the younger spouse reached age 95, some 36 years in the future. If the investment rate of return was 6.25%, their remaining funds would have exhausted in 32 years. And, at a 7.25% investment rate of return, their retained assets would have exhausted in 29 years.

As the above example illustrates, if this couple has more than $46,000,000 worth of investment assets, then making the maximum $10,000,000 in taxable gifts during 2012 will most likely leave them with sufficient income-producing assets if they survive well into their 90s. But, for couples at their age level with less than $46,000,000 of investment assets, maybe they should consider making taxable gifts in amounts less than the $10,000,000 maximum.

So, the next part of the analysis that the estate planning profession must perform is to evaluate what can be done to stop the burn at the appropriate point in the future.

A simple solution is to draft the grantor trust agreement so that the power creating grantor trust status expires at a time in the future when the grantor no longer wants to continue to pay the income taxes on the grantor trust's taxable income. What is important is that the estate planning advisors address the impact of the burn at the time the gifts in trust are contemplated so that the clients are informed of the financial impact of their taxable gifts and can make a reasoned decision in advance as to how to deal with the burn.

Another solution is to use a non-grantor trust so that there is no burn from the inception.

A simple way to create a grantor trust is to provide that one of the discretionary beneficiaries is the grantor's spouse and that trust income may be (but is not required) distributed to the grantor's spouse (FN4). In that manner, the grantor trust can make discretionary distributions to the grantor's spouse so that the distributed funds can be used to pay the income taxes caused by the burn (FN5).

Discretionary tax reimbursement clauses have been addressed by the IRS in Rev. Rul. 2004-64 (FN6) where the IRS stated that as long as there is no understanding, express or implied, that the independent trustee would exercise the discretion to reimburse the grantor for the income taxes that the grantor is obligated to pay on the grantor trust's income, that the trustee's discretion would not alone cause the inclusion of the trust in the grantor's gross estate for Federal estate tax purposes. The IRS then cautioned that such discretion, combined with other facts, may cause inclusion of the trust's assets in the grantor's gross estate. If such tax reimbursement distributions are never made, then there should not be any estate tax inclusion exposure. But, if discretionary tax distributions are eventually made because the grantor needs the financial support provided by such distributions, that may be sufficient to convince the trier-of-fact that other facts exist to find that there was an implied understanding that trust assets would be used for the benefit of the grantor. Since there are safer alternatives to deal with the burn, the author recommends that discretionary tax reimbursement clauses not be used (FN7).

The trustee of the trust can wait and make decisions at a future point in time when the grantor feels that the burn needs to be eliminated or reduced. One alternative is to change the investment mix of the trust's assets to change the character of the grantor trust's income from ordinary income to tax tax-free income, long-term capital gains, or "qualified dividends" if that rate preference is still available. Another choice for investments is to invest in assets that have the potential for appreciation in value as there is no gain to report until the assets are sold. Lastly, the trustee of the grantor trust could use some of its cash to purchase a high cash value life insurance policy as the income earned by the cash value is tax-exempt and can be accessed income tax-free by borrowing form the cash value (policy loans are not income assuming the life insurance policy is not a MEC) (FN8).

The trustee of the trust can use its discretionary power to make distributions of the income-producing assets to the beneficiaries as a way of reducing the taxable income of the grantor trust. If distributions of income-producing assets are used to reduce the grantor trust's taxable income, the grantor may not want the distributions to be made directly to the individual beneficiaries as the tax, asset protection and other benefits of dynasty trusts are no longer available. So, the question that then arises is whether the grantor trust's distributions can be made into another trust that will not be a grantor trust? The resolution of whether trust distributions can be made to another trust is determined by the language in the trust agreement, including trustee powers and the use of trust protectors, and the impact of state law.

One final word of caution is appropriate. Several advisors suggest that all that is needed to end grantor trust status for the grantor trust is to "toggle off" grantor trust status. This toggling off can be accomplished by the grantor merely taking affirmative action by releasing the power in the trust that created grantor trust status or having the trustee or trust protector cancel that power. Given that the grantor's debt obligation is cancelled by toggling off grantor trust status, the logical question to then ask is whether this cancellation gives rise to discharge of indebtedness income for Federal income tax purposes?

The narrow situation when an existing trust liability to an unrelated person is attributable to the grantor because of grantor trust status and that liability is deemed shifted to the trust when grantor trust status is terminated while the grantor is still alive is the only guidance we have as to the income tax consequences when grantor trust status is terminated (FN9). These authorities treated the liability shift as an income tax realization event, specifically as an income tax sale under Section 1001(a). These authorities all involved a liability owed to a third party and did not address a liability of the grantor. Because these authorities take the position that the shifting of the third-party liability from the grantor to the non-grantor trust is an income tax realization event, that leads to the question whether the grantor would incur discharge of indebtedness income under § 61(a)(12) when the grantor's obligation to pay the income taxes on the trust's income is shifted to the trust upon termination of grantor trust status. This issue has never been addressed by the IRS in its Regulations, in any of its official and unofficial administrative pronouncements or in the case law, and its resolution remains unclear at this time.

The IRS takes the position that the grantor does not make a gift when the grantor pays the income taxes on the trust's income because that liability is the grantor's liability, and the IRS concludes that one cannot make a gift by paying one's own liability (FN10). Because the IRS's position in Revenue Ruling 2004-64 recognizes the existence of this liability, although limited to the transfer tax consequences, it could lead one to the conclusion that when the grantor's liability is shifted to the trust, the grantor's liability is cancelled. Therefore, for income tax purposes, the grantor has to recognize discharge of indebtedness income under § 61(a)(12) of the Code (FN11).

A contrasting view is that discharge of indebtedness income should not result upon the cancellation of the grantor's obligation to pay the income taxes on the trust's taxable income. The reason for attributing items of income, deduction, and credit to the grantor under § 671 is that the grantor is deemed to be the owner of the trust property. The IRS's position of treating the grantor as the owner of the trust's assets is, therefore, consistent with and supported by the rationale in Rev. Rul. 85-13 (FN12). In other words, tax liability attaches to the owner of the property. As the deemed owner of the property, the grantor's payment of income tax is in discharge of his own obligation. The income tax cannot be an obligation owed to the trust, because the trust does not exist for Federal income tax purposes. The language of Rev. Rul. 2004-64 (FN13) supports this by stating that "any income tax [the grantor] pays that is attributable to Trust's income is paid in discharge of [the grantor's] own liability, imposed on [the grantor] by § 671."

It is only after grantor trust status terminates that the non-grantor trust springs into life as a separate entity for Federal income tax purposes. The grantor is deemed to relinquish ownership of the trust assets at that time. The trust, as owner of the assets must pay the resulting income tax liability. This transfer appears analogous to an individual who transfers income producing property by gift. While the individual owns the property, he reports the income from it, and thus pays the income tax on the income produced. Once the individual transfers the property to another person, he no longer reports its income, and thus has no corresponding obligation to pay the income taxes associated with the property. He does not, however, recognize any discharge of indebtedness income on the actual transfer of an income-producing asset by gift. Likewise, one should be treated similarly if there is a deemed transfer of an income-producing asset when grantor trust status is terminated.

Given the uncertainty of the income tax consequences when grantor trust status is toggled off, it is best not to rely upon the toggling off alternative and use any of the alternatives suggested above. The most practical of the alternatives is to perform a financial projection, decide at the time the grantor trust agreement is drafted when grantor trust status should end and have the power that creates grantor trust status automatically expire by the trust terms.

Conclusion

As the above illustrations point out, before advising a client to make the maximum tax gifts using the existing $5,120,000 exemptions available for the remainder of the 2012 year, a financial analysis needs to be undertaken, taking into account the ages of the donors, the amount of their investment assets, the character of the income generated by the investment assets owned by the grantor trust, their living and consumption expenses, the state income tax rates for their state of residence and any other factors that may impact on their financial status. Only after this analysis is performed, can the clients, with the guidance of their estate planning advisors, decide upon the level of taxable gifts to make before the end of the 2012 year.

________________________________

Footnotes:

1 Director, 39th Annual Notre Dame Tax & Estate Planning Institute, South Bend, Indiana, October 17 and 18, 2013. Adjunct Professor of Law, Graduate Program in Estate Planning, University of Miami School of Law and the Florida International University School of Law.

2 Even if the estate tax exemption is continued at an amount up to $5,000,000, there is a good possibility that the gift and estate tax exemptions will not be unified and that the gift tax exemption will be only $1,000,000.

3 Rev. Rul. 2004-64, 2004-2 C.B. 7.

4 If the trust provides that it is for the benefit of the settlor's spouse in addition to the settlor's descendants, the trust is automatically treated as a grantor trust under § 677(a)(1). A trust for the benefit of a spouse will continue as a grantor trust only as long as the settlor's spouse is living.

5 Using a spousal limited access trust (a "SLAT") allows the trust to make distributions to the beneficiary spouse to pay the income taxes created by the burn as the spouses file joint income tax returns. But, as noted in Rev. Rul. 2004-64, 2004-2 C.B. 7, the IRS will view such distributions as an implied retention of a § 2036(a) retained right to enjoyment. Caution: If both spouses make taxable gifts to separate grantor trusts, the trusts must be drafted in a way to avoid the reciprocal trust doctrine. With two separate trusts, once one of the spouses dies, the trust created by the deceased grantor will no longer be a grantor trust, and that will eliminate the burn with respect to one of the trusts. But, if both spouses continue to live well into their 90s, the burn will continue to be a factor

6 If tax reimbursement distributions are mandatory, the IRS held that the grantor has retained a right to have the trust property expended in discharge of the grantor's legal obligation and that estate tax inclusion under § 2036(a)(1) is required.

7 In several states, such as New York, discretionary tax reimbursement powers are read into the trustee's powers unless specifically addressed in the trust agreement.

8 Since the life insurance policy will be owned by a trust that is not included in the grantor's gross estate. Since the objective is to shelter the income earned by the cash value from income taxation, the insured need not be on the life of the grantor, but can be on the life a beneficiary. When high cash value life insurance policies are needed, and there will be large premium payments, the trustee should consider the use of private placement life insurance ("PPLI") products.

9 Treas. Reg. § 1.1001-2(c) Example 5; Rev. Rul. 77-402, 1977-2 C.B. 222 and Madorin v. Commissioner, 84 T.C. 667 (1985).

10 Rev. Rul. 2004-64, 2004-2 C.B. 7.

11 The IRS's statement in C.C.A. 2009-23-024 (Dec. 31, 2008) that conversion of a non-grantor trust to a grantor trust is not a transfer for income tax purposes of the property held by the non-grantor trust to the owner of the grantor trust that requires the recognition of gain to the owner is questionable.

12 1985-1 C.B. 184.

13 2004-2 C.B. 7.

Carried Away: Valuation of Carried Interests for Transfer Purposes

Tue, 13 Nov 2012 20:20:39 +0000

Carried Away: Valuation of Carried Interests

for Transfer Purposes

By: Marcus A. Ewald and Brendan R. Smith

Overview

Private equity and hedge funds represent alternative investment vehicles that continue to garner increased attention among institutional investors and high net worth individuals. These funds typically maintain investment objectives focused on providing investors with an increased level of diversification, given their relatively low correlation to more traditional investments such as cash, bonds, and stocks. Alternative investing also offers the potential opportunity for increased risk-adjusted returns, which are particularly attractive in the current market environment characterized by low interest rates, uncertain equity markets, and depressed real estate values. As a result, alternative investments have developed as a viable component within a well-diversified portfolio for accredited investors. The U.S. private equity market, in particular, continued to attract additional capital over the past decade and currently maintains over $1.0 trillion in assets under management, invested in approximately 6,000 U.S. companies FN1.

Historically characterized by reduced regulation, less transparency, and low liquidity, these funds have increasingly become the target of federal regulators and taxing authorities in recent periods amid their continued growth and corresponding manager compensation. At the same time, consistent with the overall market and economic environment, these funds realized a decline in fundraising activity and deal flow during the recent recession. Although alternative investing activity is beginning to again increase, the current challenges and market uncertainty may actually present an ideal opportunity for fund managers and principals to consider and implement certain estate planning initiatives. This article first provides a general overview of the typical fund structure and the current investing environment, and then presents various estate planning options and the related valuation implications.

Fund Structure

Private equity and hedge funds are similar in that they each provide their managers and investment principals with significant discretion to pursue a wide range of investments across multiple asset classes and portfolio companies. As compensation for their investment expertise, and in order to align their interests with those of the investors, fund managers are typically compensated through receipt of a performance fee or carried interest based on a percentage of fund profits generated above the initial invested capital and often a stipulated hurdle rate of return. The most prevalent fee structure is commonly referred to as a "2 and 20," whereby a management fee of 2% is charged on assets under management or total committed capital, and a 20% performance fee is assessed on fund profits.

As an illustrative example, the typical organizational structure and flow of funds attributable to a standard private equity fund is presented in Chart #1. The economic interest in the investment fund held by the fund managers is generally allocated into two separate components. First, the managers may invest a portion of their own capital in the fund in the form of a limited partner interest. Second, a significant portion of the managers' economic interest in the fund is attributable to the carried interest, which is independent of their respective investment contributions. As shown, after the return of the contributed capital and payment of accrued preferred returns to the limited partners, any remaining proceeds are allocated 100% to the carried interest holders until the carried interest proceeds are equal to 20% of the sum of the preferred return paid to the limited partners and the carried interest distributed, often referred to as the "catch-up" provision. Thereafter, any remaining proceeds are split 80%/20% between the limited partners and the carried interest holders.

In this example, the total cash flows realized by the limited partner interests consist of the preferred return of $587 million (4) plus the $718 million for the 80% allocation of residual profits (6). The total cash flows realized by the fund managers are then calculated as the sum of the $146 million in "catch-up" proceeds (5) plus the $180 million for the 20% allocation of residual profits (6). The total anticipated economic benefit attributable to any particular fund manager over the life of the fund may then be determined by applying his or her ownership interests in the fund and the carried interest, respectively, to the above future cash flow streams.

Current Environment

After reaching a historical peak in 2007, private equity investing in the U.S. declined precipitously to a bottom in 2009 following the financial crisis and economic recession, as fundraising activity was hindered by reduced investor confidence and increased liquidity constraints. More recently, given the continued uncertainty in the debt markets and concerns over the European crisis, activity in the private equity markets has remained steady, and stagnated to some extent, in terms of fundraising, deal flow, and exit activity. Chart #2 indicates that there were 321 completed private equity deals totaling $55 billion in the first quarter of 2012, which was the lowest quarter by number of deals since the third quarter of 2009 and the lowest by dollar value since the fourth quarter of 2009. As shown in Chart #3, the number of funds holding final closes remained near the low levels experienced in recent quarters, with 26 funds closed in the first quarter of 2012, raising $20 billion in total capital, compared to 28 and 33 funds raising $18 billion and $19 billion in total capital in the third and fourth quarters of 2011, respectively. Additionally, although activity has been relatively stable, the outlook for future private equity exits indicates certain signs of strength due to the large company inventory in private equity portfolios and the amount of cash available to private equity firms FN2. Notwithstanding the above, a sustained economic recovery is likely necessary in order for private equity funds to achieve results consistent with levels prior to the 2008 financial crisis.

In addition to private equity, the hedge fund industry is also in the process of recovering from recent depressed levels, as new hedge fund launches in the first quarter of 2012 increased to a level not reached since 2007. At the same time, hedge fund capital rose to a record level of $2.13 trillion, according to the latest Market Microstructure Industry Report, released by Hedge Fund Research, Inc. This trend is supported in part by declines in average management and incentive fees, increases in fund transparency and risk management capabilities, and perceived opportunities amid volatile market conditions. Further, new fund launches totaled 304 in the first quarter of 2012, narrowly eclipsing the 298 launches in the first quarter of 2011 for the highest quarterly total since the fourth quarter of 2007. However, hedge fund liquidations also increased during the first quarter of 2012, with the 232 funds closing representing the highest quarterly liquidation total since 240 funds closed in the first quarter of 2010 FN3.

Estate Planning Options

Carried interests in private equity or hedge funds present a particularly useful opportunity to transfer assets from an estate in a tax-efficient manner. This is primarily due to the fact that carried interests generally maintain a relatively low current value given the risk inherent in such instruments. This risk reflects that the realization of carried interest proceeds is generally subject to multiple factors that are speculative in nature. At the same time, such proceeds are subordinated in that they are only realized after providing a return of capital and a preferred return to the investors. Moreover, the inherent risk is particularly prevalent in newly formed funds, for which there is no meaningful historical track record of performance. The resulting low present value of the carried interest provides for the significant potential for meaningful asset appreciation that may be realized after a transfer from the estate. In this manner, the donor or seller would avoid gift and estate taxes on such appreciation. At the same time, an added benefit of transferring a carried interest, rather than a direct capital interest in the fund, avoids the need to provide cash to the transferee to fund future potential capital calls.

In consideration of the above, a number of complexities need to be considered, particularly with respect to §2701 of the Internal Revenue Code. Specifically, certain issues may arise in gifting a carried interest while retaining a capital interest in the fund, as the carried interest is considered to be a separate class of investment that is junior to the capital interest. As a result, the Service may ultimately determine the gift as the combined value of the carried interest and capital interest, resulting in a significant increase in transfer taxes. Multiple options are available to avoid such treatment, and are generally outside the scope of this article. Thus, managers and other holders of carried interests should consult with estate planning attorneys experienced in these matters. In general, however, options include 1) directly transferring an equal percentage of both the carried interest and the capital interest, often referred to as a vertical slice; 2) transferring common interests in a limited liability company or similar family investment vehicle that has been funded with both the carried interest and capital interest; and 3) transferring only the economic return on the carried interest, rather than the carried interest itself, through a carry derivative.

Valuation Implications

As noted, a number of estate planning options may be available to principals for purposes of transferring their respective economic interests in a fund's carried interest. Regardless of the selected planning technique, a valuation of the carried interest itself is generally required. In some respects, the valuation of a carried interest is similar to the valuation of other assets in that value is principally derived based on the ability to generate investment returns in the form of future cash flow. However, carried interests present challenging valuation assignments in that they represent unique assets requiring careful consideration of a number of additional factors. The most commonly utilized valuation methodologies include a Discounted Cash Flow Method and an Option Pricing Method.

Discounted Cash Flow Method

The Discounted Cash Flow ("DCF") Method 1) projects a carried interest's expected future cash flows and 2) discounts them at a rate of return commensurate with the risk involved in realizing those cash flows. First, the projection of future cash flows is premised on the fact that carried interests represent a share in the residual claim on a fund's distributions only after the return of invested capital and the payment of fees and accrued preferred returns to the limited partners. As such, the future cash flow potential of the carried interest is dependent on the fund earning a sufficient rate of return to cover fees and preferred returns. Given this unique structure involving the flow of funds, a number of factors and assumptions must be carefully considered in preparing future projections for the carried interest. Certain of the more salient considerations are outlined as follows.

Committed Capital: Investors in private equity and hedge funds are typically limited to accredited investors that must commit to making significant investments, often in excess of $1.0 million. As a result, the pool of potential investors is limited and may be further limited in the current market environment due to liquidity constraints and reduced investor confidence. Depending on the stage of the subject fund, the valuation professional should hold extensive discussions with fund management regarding its fundraising targets, and then consider the reasonableness of such targets in the context of the current market environment.

Capital Drawdown: The committed capital amounts are drawn upon at the discretion of the fund managers over time and put to work in various portfolio investments. The future cash flows of the fund, and thus the carried interest, are dependent upon the ability to successfully identify and exploit profitable investment opportunities. There is significant risk not only in the ability to identify suitable opportunities, complete due diligence, and close each transaction, but also in the anticipated timing for which to do so. Thus, the DCF Method requires an additional level of complexity since a fund's potential investments must be categorized into separate investment phases based on the expected time period for capital deployment. Additionally, any existing investments must also be specifically accounted for utilizing the value of the investment indicated by the fund's most recent mark-to-market value estimation, if available. Evaluation of existing investments can be of particular significance in the case that an investment has already realized a significantly positive or negative return.

Internal Rate of Return ("IRR"): The IRR represents the annual rate of growth that an investment may be expected to generate. The IRR may be derived upon consideration of a number of sources, including 1) past performance of the fund managers, 2) market data compiled by sources such as State Street Corporation and Credit Suisse, and 3) discussions with management. The IRR impacts the expectation of the final value to be realized upon the exit of each investment and, in this regard, obviously represents a rather sensitive input to the valuation process. Additionally, consideration must be given to the source of the market data utilized in selecting an IRR (i.e., net of expenses, net of management fees, net of the carried interest, etc).

Exit Timing: The ultimate IRR realized by a fund is to a large extent also impacted by the expected timing for an exit event. In other words, the longer the holding period incurred for a particular investment, the lower the IRR realized by the fund, holding the exit value constant. The estimation of an appropriate holding period is thus an important consideration and involves an analysis of 1) the types of investments to be held by the fund, 2) various empirical studies of historical market data, and 3) the current investing environment. In particular, although private equity exits have increased since the first quarter of 2009, exit activity remains below historical levels due largely to a reduction in the availability of transaction financing. When compared against the significant amounts of capital raised in 2004 through 2007 (i.e., funds that would ordinarily begin harvesting investments now), it becomes apparent that exit activity must increase significantly in order to avoid continued extended holding periods.

Capital Allocation: Each of these factors is utilized in estimating the amounts and timing of the estimated future cash flows of the fund. These future cash flows must then be allocated among the limited partners and the carried interest holders based on the specific terms and "waterfall" provisions of the particular fund. For this purpose, the valuation professional is required to comprehensively review and understand the fund's allocation structure, as typically defined in its partnership agreement, offering memorandum, prospectus, and other fund documents.

The projected cash flows to the carried interest in each year are then discounted to their present value equivalent at an appropriate rate of return. The selected carried interest rate of return is one of the more important, and difficult, inputs to the valuation analysis. First, the rate of return must incorporate the risk and volatility of the underlying investments held by the fund. However, since the hurdle or preferred returns to the limited partners must be paid before any net proceeds are paid to the carried interest holders, the projected cash flows attributable to the carried interest are riskier than the projected cash flows associated solely with the invested capital. As a result, the rate of return applicable to the carried interest is higher than the gross portfolio rate of return of the underlying assets because of its residual claim on the returns produced by these assets. A number of factors, outlined below, should be considered in order to fully support the incremental premium that an investor would require to invest in the carried interest.

Qualitative Factors: Ultimately, a carried interest represents a subordinated interest in the returns generated by a fund. Thus, an investor in a carried interest would require a premium to incorporate the fact that it maintains only a residual claim on a fund's returns. The extent of the premium is subject to the facts and circumstances of each situation and requires extensive valuation experience. Various qualitative factors that should be considered focus on those that would reduce the ability to realize significant carried interest proceeds, including the level of the hurdle or preferred return, the strategy of the fund, the current market environment, etc.

Legislative Actions: Proposals by politicians to balance the federal budget deficit, raise tax revenues, and support fiscal stimulus continue to consider an increase in the taxes on carried interests. The proposed changes include an increase in the federal tax from a current rate of 15.0% (i.e., carried interests are currently taxed at the long-term capital gains tax rate) to the marginal ordinary income tax rate, which can be as high as 35.0%. This change amounts to a substantial increase in the tax liabilities for carried interest holders. As such, this change would significantly decrease the value of carried interests and represents an additional risk factor that should be considered in deriving the appropriate rate of return.

Quantitative Analysis: The incremental premium may also be algebraically calculated based on the premise that the internal rate of return for the investment portfolio as a whole should reflect a weighted average of the separate rates of return required by the individual investors, which would include specifically 1) the limited partners as providers of the investment capital and 2) the investment professionals as the carried interest holders. In other words, given the overall IRR and weighting to the limited partners (based on market data) and the specific preferred return of a fund, it is possible to solve for the rate of return attributable to the carried interest holders.

Finally, the selected carried interest rate of return is applied to the annual projected cash flows attributable to the carried interest to derive an indication of the present value of the carried interest.

Option Pricing Method

An alternative to the DCF Method is to compare the features of a carried interest to the features of a call option. A carried interest position is similar to a call option in that it represents the right to the value of an investment above a predetermined level (i.e., the strike price). In particular, a carried interest's "strike price" is the committed capital plus the hurdle or preferred return. Based on the similarities of the features of a carried interest compared to a call option, the Black-Scholes Option Pricing Model ("Black-Scholes Model") may be used as a second indication of the present value of a carried interest.

The Black-Scholes Model is the predominant method in estimating option prices and represents an arbitrage-pricing model that was developed using the premise that if two assets have identical payoffs, they must have identical prices to prevent arbitrage (i.e., riskless profit). The Black-Scholes Model calculates the price of a traditional call option by analyzing the volatility and opportunity cost of investing in the underlying asset. The Black-Scholes Model's formula and individual components are as follows:

C = SN(d1)-Xe-rTN(d2)

Asset Value (S): Similar to the DCF Method, the fund's potential investments are categorized into investment phases. In this case, the asset price is equal to the projected capital to be deployed for each anticipated investment, reflecting the initial value of capital available to both the limited partners and the carried interest.

Strike Price (X): Based on the terms of the fund agreement, each investment phase may require the valuation of multiple call options, with varying strike prices according to the asset values at which there is a change in the manner in which proceeds are allocated among the limited partner investors and the carried interest holders. In other words, the limited partners first receive 100% of proceeds until the return of invested capital and receipt of the preferred return (Strike Price #1). Thereafter, funds typically provide for a catch-up provision allowing for a disproportionate allocation of proceeds to the carried interest holders until the point at which their cumulative distributions equal a standard allocation (typically 20%) of total amounts distributed (Strike Price #2) FN4. Beyond that point, all remaining proceeds are typically allocated 20%/80% (or other stipulated allocation) to the carried interest holders and limited partner investors, respectively.

Time to Maturity (T): Estimated investment holding period for each investment phase.

Risk-Free Rate of Return (r): Return for U.S. Treasury securities at a point on the yield curve corresponding to the estimated holding period for each investment phase.

Volatility (N(d1) and N(d2)): One of the more sensitive and difficult inputs, volatility must be derived based on consideration of market data, particularly those indexes with similar investment strategies and characteristics as the underlying portfolio investments of a particular fund.

The Black-Scholes Model is applied to each separate investment phase over the life of the fund, resulting in multiple option value calculations for each investment phase (i.e., one for each strike price). The allocations of the resulting call option values attributable specifically to the carried interest are then calculated for each investment phase. An example of this calculation is presented in Chart #4 which for illustrative purposes involves the calculation of two option values for each investment phase. First, the carried interest receives a certain catch-up percentage (in this case 100%) of the asset value above Strike Price #1 until the asset value exceeds Strike Price #2. At this point, the allocation of proceeds changes to a stipulated sharing ratio between the carried interest holders and the limited partner investors (typically 20%/80%). As a result, the carried interest receives 1) 100% of the incremental option value between the first and second call options, and 2) 20% of the value attributable to the second call option. Finally, due to the fact that these option values typically represent future values (i.e., call option values as of future investment dates), the present values of these amounts for each investment phase are calculated based on a rate of return that incorporates the risk of holding an investment in the carried interest proceeds (as in the DCF Method).

Monte Carlo Method

The previously mentioned valuation methodologies incorporate a number of inputs that require a certain degree of uncertainty, particularly given that the valuation is often performed at the initiation of a fund before a historical record of investment performance has been established. In order to appropriately address such uncertainty, a Monte Carlo analysis should be considered to supplement the more traditional DCF Method and Black-Scholes Model, which are more deterministic in nature. In contrast, Monte Carlo methods are probabilistic in nature and involve statistical sampling techniques that simulate the various sources of uncertainty and calculate an average or expected value over a range of thousands of resultant outcomes.

The application of a Monte Carlo analysis involves first developing an income-based analytical model similar to the DCF Method and Black-Scholes Model that incorporates many of the same drivers of value, such as fund size, expected return, holding period, volatility, etc. The key assumptions revolve around the assumed distributions and distribution parameters for a particular fund.

A Monte Carlo simulation analysis can then be performed on the model by running multiple scenarios incorporating a range of values for the key value drivers. The Monte Carlo simulation ultimately returns an expected value based on the outcomes for the numerous scenarios and, in this regard, provides a significantly comprehensive and robust analysis. Thus, the valuation professional should have experience with statistical modeling in general and Monte Carlo analyses in particular.

Hedge Fund Carried Interests

Consideration of a Monte Carlo methodology is particularly useful and effective with respect to the valuation of hedge fund carried interests. To this point, our discussions have primarily considered the valuation of a typical private equity carried interest. The characteristics of a hedge fund carried interest, however, may differ quite substantially from those of a private equity carried interest, and thus render consideration of a statistical analysis such as a Monte Carlo method particularly meaningful.

Hedge fund carried interests are calculated and distributed at the end of each calendar year or reporting period and typically range from 15% to 20% of any new appreciation in the net asset value of any given capital contribution. New appreciation, if any, equals the amount by which the net asset value of a capital contribution exceeds the high water mark ("HWM"), which represents the greater of 1) the highest net asset value of such capital contribution as of the end of any previous reporting period, or 2) the amount of the initial capital contribution.

Based on these features, the aggregate value of a hedge fund carried interest can be characterized as a call option written on the net asset value of the fund with a strike price equivalent to the fund's aggregate HWM. However, depending on the returns achieved by the fund, the HWM is reset as of the end of each reporting period, thereby introducing an additional variable in the valuation process. In other words, the option value of the carried interest changes as the strike price continually adjusts. Given these relevant features, the value of a hedge fund carried interest can be characterized in terms of a path-dependent option pricing framework.

The valuation of a hedge fund carried interest requires the following key components.

Fund Size: Projected fund size must consider multiple components and inputs, including initial capital raised, expected return, volatility of returns, management fees and fund expenses, and capital contributions and withdrawals. The projection and summation of these factors generate increases and decreases in fund size from one period to the next.

Fund Life Cycle: Several empirical studies have attempted to quantify the various factors that influence the life cycles of hedge funds. The valuation professional must appropriately consider the specific characteristics of the fund in addition to industry trends in order to appropriately capture the anticipated life of the fund.

Calculation of Carried Interest Proceeds: The HWM must be calculated and reset appropriately in each period in order to calculate the present value of the carried interest proceeds for each reporting period of the fund's life.

Conclusion

Private equity and hedge funds represent a significant source of private wealth for their principals and managers in the form of potential carried interest or incentive compensation. However, such incentive compensation will often not be received until an uncertain future date and is further dependent upon a number of factors. Thus, significant risk exists regarding whether such amounts will ever be fully realized, particularly at the time of the initiation of a fund before it is fully invested.

This risk reduces the overall value of the incentive compensation, a factor that is further exacerbated in the current market environment. In particular, funds are realizing more difficult fundraising efforts, extended holding periods, and lower IRRs, all of which reduce the value of potential incentive compensation. At the same time, there is additional risk in the form of increased regulation and scrutiny imposed by the recent Dodd-Frank legislation, as well as ongoing political pressures to increase the tax rates attributable to this form of income. As a result, the current market environment presents significant opportunities to structure estate plans around the carried interests and performance fees at attractive valuations.

Marcus A. Ewald, CFA is a Director in the Valuation & Financial Opinions Group at Stout Risius Ross (SRR). He specializes in valuations prepared for transaction advisory purposes, estate and gift taxation, succession planning, and other tax, corporate, and litigation related matters. He serves as leader of SRR's Consumer Staples practice and also has extensive valuation experience across numerous industry segments, including the valuation of limited partner interests and carried interests in private equity and hedge funds, as well as their underlying portfolio companies. Mr. Ewald can be reached at +1.312.752.3346 or mewald@srr.com.

________________________________

Footnotes:

1 The PitchBook Private Equity Decade Reports, Vol. 1: Fundraising 2001-2010, PitchBook Data, Inc., 2011, 3.

2 The Private Equity 2Q 2012 Breakdown, PitchBook Data, Inc.

3 Hedge Fund Launches Accelerate as Support for Bank Regulation Builds, Hedge Fund Research, Inc., 15 June 2012.

4 Based on the terms of each individual fund agreement, it may be necessary to consider additional strike prices in the event that the catch-up percentages for the carried interest holders differ at varying asset values.

Warding Off Analysis Paralysis

Tue, 13 Nov 2012 18:13:22 +0000

Warding Off Analysis Paralysis

By: David T. Leibell & Daniel L. Daniels

We've all heard the family business statistics before, but they're worth repeating FN1. Approximately 90 percent of U.S. businesses are family firms. They range in size from small "mom-n-pop" businesses to the likes of Walmart, Ford, Mars and Marriott. There are more than 17 million family businesses in the United States, representing 64 percent of gross domestic product and employing 62 percent of the U.S. workforce. Thirty-five percent of the businesses that make up the S&P 500 are family controlled. Family businesses are also more successful than non-family businesses, with an annual return on assets that's 6.65 percent higher than the annual return on assets of non-family firms. Unfortunately, only a little more than 30 percent of family businesses survive into the second generation, even though 80 percent would like to keep the business in the family. By the third generation, only 12 percent of family businesses will be family-controlled, shrinking to 3 percent at the fourth generation and beyond.

The disconnect between what 80 percent of families intend and the far bleaker reality can primarily be attributed to a failure to plan effectively for both the family dynamics issues and the complex estate strategies necessary for successful family business succession. A companion piece to this article, titled "Succession Planning," in the March 2011 issue of Trusts & Estates FN2 dealt exclusively with the role that family dynamics plays in the success or failure of family business succession planning. This article will focus exclusively on the technical estate planning issues involved in family business succession.

Take it in Phases

Estate planning for a family business owner is extremely complex. It can involve virtually all of the tools in the estate planner's toolbox, including straightforward testamentary planning, advanced gift planning, insurance issues, buy-sell agreements, and corporate recapitalizations. As estate planners, if we attempt to address all of these issues at once, we risk overwhelming the client, resulting in no estate planning getting done at all. Some call this "analysis paralysis." Our experience has shown that we can often avoid analysis paralysis by breaking down the planning into Phase I and Phase II.

Phase I planning involves those steps the business owner can take that produce a relatively large benefit to the client or his family but at a relatively low cost. In using the term "cost," we're not thinking solely of professional fees. Instead, for a business owner, the costs of implementing a planning idea can also include such things as whether the strategy involves a loss of control or access to cash flow, a significant investment of the owner's time, or even the emotional cost of addressing a particular family issue. For a business owner, essential elements of Phase I planning include testamentary transfer tax planning, planning for the management of assets left to a surviving spouse or children, asset protection planning, incapacity planning, liquidity planning, including consideration of a buy-sell agreement and life insurance.

Phase II estate planning for the business owner involves those planning ideas that may provide a significant benefit to the owner or his family but at a greater cost in terms of a greater commitment of the owner's time in implementing the plan, more complexity and professional fees, loss of control or access to cash flow, or all of the above. Examples of Phase II planning concepts include liability protection planning, advanced lifetime wealth transfer planning, and testamentary planning at a level of sophistication beyond that considered in Phase I.

Phase I

Testamentary Transfer Tax Planning

Under current law, a federal estate tax is imposed on all assets owned by an individual at death at a rate of 35 percent. Each individual is entitled to an exemption from the tax of $5 million. There's also an unlimited exemption from the tax for transfers between spouses, known as the marital deduction, provided that the recipient spouse is a U.S. citizen FN3. If an individual transfers assets to grandchildren, or to certain types of trusts for children that terminate in favor of grandchildren or more remote descendants, a separate generation-skipping transfer (GST) tax is imposed, again at a 35 percent rate and with a $5 million exemption. As of Jan. 1, 2013, unless Congress acts to change the law, the top federal estate and GST tax rate will rise to 55 percent and the exemption will decrease to $1 million FN4. In addition, some states impose an independent state-level estate tax at rates that can run as high as 16 percent or more. There are some simple steps, however, that a business owner can take to minimize these taxes at his death, including:

Two-share tax planning.

If the owner is married, her will or revocable trust agreement should contain planning to guarantee optimal use of both spouses' federal estate tax exemptions. Traditionally, this guarantee was accomplished by the business owner dividing her estate into two shares. The first share, sometimes called the "exemption share," would be an amount equal to the owner's federal estate tax exemption and the second share, sometimes called the "marital share," would be the balance of the owner's estate. The exemption share would pass to a trust, sometimes called a "credit shelter trust" or "bypass trust," and the marital share would pass outright to the surviving spouse or to a qualifying marital trust for his benefit. The surviving spouse could be given generous rights over the credit shelter trust, including perhaps the right to the income, principal as needed and even a limited testamentary power of appointment, but would not be given "enough" rights to be called the owner of the trust for estate-tax purposes. In this way, the trust would pass through the owner's estate with no federal estate tax (because it utilizes the owner's estate tax exemption) and through the surviving spouse's estate with no estate tax, as well (because the surviving spouse didn't own the trust for tax purposes). There would be no federal estate tax on the marital share at the owner's death because of the unlimited marital deduction. At the surviving spouse's death, the first $5 million of assets included in his estate would pass to the children, tax-free, as a result of the surviving spouse's estate tax exemption. As a result, the couple would have succeeded in sheltering two estate tax exemptions - or $10 million under current law - to the next generation rather than only one. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Act) provides for portability of estate tax exemptions between spouses. Thus, it shouldn't be necessary to use the two-share structure described to shelter a full $10 million of assets from tax for the children's generation. However, in our practice, we've generally recommended that clients continue to use the two-share structure rather than relying on portability for a number of reasons, including 1) The statute establishing portability is scheduled to expire at the end of 2012; 2) relying on portability fails to capture increases in the value of the exemption share between the date of the first and second spouses' deaths; 3) there's no portability of GST tax exemptions; and 4) relying on portability precludes use of the general benefits of a credit shelter trust, including creditor protection, the ability to sprinkle income among various trust beneficiaries, thereby potentially saving income tax for the family, and the ability to sprinkle principal among various trust beneficiaries, thereby possibly enabling greater tax-free gifting than would be available by relying on portability.

Generation skipping planning.

The two-share plan described previously can be supercharged by adding generation skipping planning. Under a generation skipping plan, the wills or revocable trust agreements of the owner and spouse would provide that the $10 million that the couple would otherwise transfer outright to the children tax-free using the two-share planning would instead be transferred to generation skipping trusts for the children. The trusts would be designed so that each child could receive income and principal from his trust as needed, but the child wouldn't be treated as the owner of the trust for estate tax purposes. As a result, to the extent the trust assets weren't consumed by the child during the child's lifetime, they would pass to the child's children estate and GST tax-free FN4.

Spousal Marital Trusts

If the business owner doesn't want her spouse to have control over inherited assets, or if she simply wants to ensure that the spouse can't leave the inherited assets to a new spouse should he remarry after the business owner's death, the business owner can establish a marital trust to receive the spouse's share of the estate. The business owner would name some trusted individual or institution to serve as a trustee of this trust, often with the spouse as a co-trustee. The spouse would receive income for life, and principal too, if needed. Upon the surviving spouse's death, the trust terms mandate that the trust assets pass to the owner's children; thereby eliminating the ability of the spouse to give those assets to a new spouse should he remarry.

The marital trust may provide an additional benefit for certain business owner families. Consider the following two examples. In the first example, suppose the business owner holds 90 percent of the stock in "Bizco," with the remaining 10 percent owned by outside shareholders. If the owner leaves the Bizco stock outright to her husband (and the husband is a U.S. citizen), the husband will inherit it tax-free. However, when the husband later dies, he now owns a 90 percent interest in Bizco which, presumably, will be valued in the husband's estate with a control premium. In the second example, suppose instead that, during their lifetimes, the business owner and her husband were to divide the stock between them, with the owner taking 45 percent and the husband taking 45 percent. Further suppose that instead of leaving the stock outright to her husband, the owner were to leave the stock to a marital trust for his benefit. At the husband's death, instead of his estate including one 90 percent block of stock, it includes a 45 percent block owned by the estate and a second 45 percent block owned by the marital trust. If the marital trust is properly designed, case law supports the estate taking the position that the two blocks of stock should be valued separately, with the result that a minority interest discount should be available in the second example, as opposed to the control premium that applied in the first example FN5. In our practice, we find that, at least with business owners who are in long, happy marriages, this technique is a simple - and for many business owners, painless - way to reduce the value of the business owners' estates for tax purposes.

Asset Protection Trusts

Many business owners won't want to pass ownership of the business outright to a child or other descendant. Assets left outright to a child are exposed to the claims of creditors, divorcing spouses, and others who may influence the recipient to sell or otherwise use the assets in a manner inconsistent with the business owner's intentions. If the business owner instead leaves the assets to a properly designed asset protection trust, the assets can receive a significant measure of protection from the claims of the descendant's creditors or divorcing spouse. In our practice, we often find that business owners think that they already have such protection in their wills or revocable trust agreements, but are surprised to learn that if the descendant has the right to withdraw the trust funds at a particular age, the trust may not provide much protection at all.

Liquidity and Life Insurance

For a wealthy business owner, the tax planning described typically won't be sufficient to shelter the entire estate from federal and state estate taxes. Federal and state estate taxes are typically due no later than nine months after death. And an astonishing 93 percent of family business owners have little or no cash flow outside the business, according to the 2007 Laird Norton Tyee Family Business Survey FN6. Accordingly, to avoid a forced sale of the business at suboptimal prices, if there's a transfer tax exposure at the owner's death, it's critical to ensure that sufficient liquidity is available to pay the tax. This result can be accomplished through the use of buy-sell agreements in combination with life insurance planning.

1. Buy-sell agreements.

A buy-sell agreement is a contractual arrangement providing for the mandatory purchase (or right of first refusal) of a shareholder's interest, either by 1) other shareholders (in a cross-purchase agreement); 2) the business itself (in a redemption agreement); or 3) some combination of the other shareholders and the business (in the case of a hybrid agreement) upon the occurrence of certain events described in the agreement (the so-called "triggering events"). The most important of the triggering events is the death of a shareholder, but others include the disability, divorce, retirement, withdrawal, or termination of employment or bankruptcy of a shareholder.

A buy-sell agreement's primary objective is to provide for the stability and continuity of the family business in a time of transition through the use of ownership transfer restrictions. Typically, such agreements prohibit the transfer to unwanted third parties by setting forth how, and to whom, shares of a family business may be transferred. The agreement also usually provides a mechanism for determining the sale price for the shares and how the purchase will be funded.

Other reasons for a buy-sell agreement depend on the party to the agreement:

The founder - For someone who's built the business from nothing and feels that no one can run it as well as she can, a buy-sell agreement allows the founder to maintain control while providing for a smooth transition to her chosen successors upon her death or disability. Structuring a buy-sell agreement can provide a non-threatening forum for the founder to begin thinking about which children should be managing the business in the future and which should not. Typically, a founder will want only those children who are active in the business to own a controlling interest in the stock, but will want to treat all children equally in terms of inheritance. A buy-sell agreement allows the founder to sell control to children who are active in the business and use some of the proceeds from the sale to provide for the children who aren't active in the business. By specifically carrying out the founder's intent, a properly structured buy-sell agreement avoids the inevitable disputes between the two sets of children with their competing interests.
The next generation - For those children who are active in the business, a properly structured buy-sell agreement will allow them to purchase the founder's shares over time on terms that have been negotiated at arm's length, won't cripple their ability to operate the business, and may be at least partially paid by life insurance proceeds on the life of the founder. The agreement also provides a mechanism for not having to go into business with siblings (or spouses of siblings) who aren't active in the business.
The business - A buy-sell agreement can help keep the business in the family and assure a smooth transition to the next generation. The agreement can also void transfers that would result in the termination of the entity's S Corporation status.
The founder's estate - A buy-sell agreement can provide: 1) a market for an illiquid asset avoiding a fire sale because the sale price is determined by the agreement; 2) liquidity to pay any estate taxes; and 3) money for a surviving spouse. But under virtually no circumstances in the family business context will a "low ball" value for selling the business be respected by the Internal Revenue Service (so don't try it) FN7.

2. The role of life insurance.

Business owners' estates are inherently illiquid, with the business and the business real estate often representing the lion's share of the value of the estate. Family business owners are often good candidates for life insurance, which can provide instant liquidity at the business owner's death to pay estate taxes, provide for children who aren't active in the business, fund the buy-sell agreement, and provide for a spouse from a second marriage.

We typically suggest that the business owner consult with a highly qualified insurance professional in connection with liquidity planning. We find that the type of life insurance the insurance professional usually recommends in the family business succession context is permanent insurance and in particular guaranteed universal life insurance, which typically provides the largest guaranteed death benefit for the lowest cost. Although life insurance proceeds aren't income taxable to the beneficiary, such proceeds are typically taxable in the insured's estate. That's why it's so important for the insurance to be owned by an irrevocable life insurance trust (ILIT) in which the proceeds won't be subject to estate tax because they aren't considered owned by the business owner's estate. ILITs can be structured to own single life insurance policies that pay out on the death of the business owner or second-to-die life insurance policies, which pay out on the death of the survivor of the business owner and her spouse, which is typically when estate taxes are due. It's important to remember that if a business owner transfers an existing life insurance policy and dies within three years of the transfer, the proceeds are brought back into her taxable estate under IRC Section 2042. Whenever possible, structure the transaction to have the insurance trust be the initial purchaser of the policy so the insurance is out of the business owner's estate from day one.

Paying for the insurance depends on who owns the policy. If the insurance is owned by the other shareholders or the corporation in the context of a buy-sell agreement, there should be no gift consequences on paying premiums. Sometimes the insurance ownership is bifurcated between the business owner and the corporation or between the business owner and certain family trusts. This bifurcated ownership is known as split dollar, and it's crucial that the business owner work with an attorney and an insurance professional who are both highly experienced in the area of split-dollar planning, since it's filled with tax traps. If the insured is providing money to pay the premiums on the insurance owned by the irrevocable insurance trust, she can often avoid paying gift tax by qualifying the transfers as present interests gifts to the trust following the process set forth in Crummey v. Commissioner and its progeny FN8. If available annual exclusions are insufficient to pay premiums, the business owner can consider funding the insurance trust with some or all of her $5 million federal gift tax exemption. Remember, the $5 million exemption is only available, unless extended, through Dec. 31, 2012.

Incapacity Planning

A final piece of Phase I is incapacity planning. If the owner becomes incapacitated and no planning has been done, the family may be forced to ask a court to appoint a guardian or conservator to manage the owner's financial and personal affairs. This result can be avoided in almost all cases through the simple expedient of a properly designed power of attorney and health care proxy naming the appropriate individual to make financial and health care decisions in the event of the owner's incapacity. As a power of attorney can sometimes be an unwieldy document to make decisions regarding a complex business enterprise, we often suggest that the business owner also execute a revocable living trust agreement. The owner's interest in the business can be transferred to the revocable trust during the owner's lifetime and, while the owner has capacity, she can be the trustee. Upon the owner's incapacity, a new trustee would step in to make decisions regarding the business interests held in the trust. This approach can be preferable to a power of attorney because the trust agreement can include detailed instructions for the trustee as to how to make decisions relating to the business. The trust agreement can also provide greater flexibility for appointing additional or successor trustees; this can be more difficult to do with a power of attorney.

Phase II

Liability Protection Planning

The business activities may give rise to liability risks. A well-constructed estate plan will address these risks and consider methods for insulating the owner's assets from those risks. While it's tempting for clients - and sometimes for their advisors - to think that liability protection mainly involves complex trust or corporate structures to shelter assets, we usually advise clients to first visit with their property and casualty insurance advisor to ensure that their liability insurance is adequate. A properly structured property and casualty insurance program not only can protect the business and the business owner from catastrophic losses, but also often will provide a benefit that's less discussed but perhaps equally important - the payment of legal defense costs in the event of a lawsuit against the business owner or the company. We typically advise a thorough review of the insurance programs for both the business and the business owner, including implementing a healthy amount of umbrella coverage over and above the owner's primary insurance coverage.

For further liability protection, the business owner might consider "insulation" strategies. One insulation strategy involves segregating each of the business's risky activities inside its own liability-shielding structure such as a corporation, limited liability company (LLC) or limited partnership. For example, suppose that the owner's primary business is manufacturing and that the business is operated in a building owned by the business owner individually. Each activity - the manufacturing business and the operation of the real estate in which the business is housed - should be insulated inside its own corporation or other entity. That way, in the event of a lawsuit involving the manufacturing activities, arguably only the assets of the manufacturing business itself, and not the real estate owned in the separate entity or the business owner's other assets, are exposed to the lawsuit. Although a full discussion of choice of entity is beyond the scope of this article, it often will be beneficial for the chosen entity to be a partnership or LLC, rather than a corporation, because the partnership or LLC receives pass-through status for income tax purposes FN9.

Advanced Lifetime Planning

For many advisors, wealth transfer planning is the starting point for planning for the business owner. For us, however, discussions about transferring assets to save estate taxes or to bring the junior generation into the business generally don't begin until after Phase I of the plan has been implemented. We find that this approach produces two benefits. First, it helps ensure that the business owner gets some plan in place instead of engaging in endless and sometimes confusing discussions about lifetime wealth transfer planning, all the while possibly having done nothing to ensure the orderly passage and operation of the business in the event of the owner's death or incapacity. Second, time after time, we find that the very process of going through Phase I planning can help the business owner develop a comfort level with estate planning in general that can make it easier to come to terms with the hard decisions that often need to be made about asset transfers, management succession, loss of control, or loss of access to cash flow, in implementing Phase II of the plan.

As complex as lifetime wealth transfer can be, from the standpoint of taxes alone, it's actually quite simple. If an individual attempts to transfer assets during life to avoid an estate tax, the transfer will generally instead be subject to a federal gift tax. Since the gift tax and the estate tax apply at the same rates and generally have the same exemptions, there should be no incentive for an individual to transfer wealth during life as opposed to waiting to transfer it at death. In effect, by enacting the gift tax as a companion to the estate tax, Congress created an "airtight" transfer-tax system. There are, however, leaks in that system. The three primary examples of those leaks are removing value from the system, freezing value within the system, and discounting values within the system.

Removing value from the system is hard to do. In most cases, if an individual makes a gift during lifetime, that gift is brought back into the taxable estate at death for purposes of calculating the estate tax on the individual's estate. However, there are two exceptions to this general rule, which are the annual gift tax exclusion and the "med/ed" exclusion. If an individual makes a gift using his $13,000 annual gift tax exclusion, the gifted property is entirely removed from the taxable estate. Individuals are also permitted to make gifts of unlimited amounts for tuition and certain medical expenses, as long as the payment is made directly to the provider of services. Such med/ed gifts are entirely excluded from the taxable estate.

Freezing value within the system usually connotes the individual making a gift using some or all of his lifetime exemption from federal gift tax. For example, a business owner might make a gift of $5 million worth of stock in the business to a child. Upon the owner's death, the $5 million gift is brought back into the estate for purposes of calculating the owner's estate tax. However, it's only brought back into the estate at its value at the time the gift was made and should be sheltered from tax at that time via the use of the owner's $5 million estate tax exemption FN10. Accordingly, if the value of the gifted property increases between the date of the gift and the date of the owner's death, the appreciation avoids transfer tax. That is to say, the owner succeeds in "freezing" the value of the gifted property at its date-of-gift value.

A holy grail of estate planners has been to find a way of freezing the value of an asset at some number lower than what it is actually "worth" to the owner's family, also known as discounting values. Suppose a business owner owns all of the stock in business with an enterprise value of $5 million. If the business owner gives all of the stock to her child, she will have made a taxable gift of $5 million. On the other hand, suppose that the business owner gives half the stock to one child and half to the other child. An appraiser is likely to opine that the interests received by the children are subject to lack of control discounts, since either child could deadlock the other in a vote involving the stock. If the appraiser applies, say, a 20 percent lack of control discount, the value of the gift would be reduced to $4 million. Accordingly, the business owner succeeds in freezing values at something less than the full value of the business in the eyes of the family as a whole FN11.

One of our favorite examples of a technique that can remove, freeze, and discount values all in one fell swoop is the spousal estate reduction trust (SERT). In a typical SERT, the owner creates an irrevocable trust, naming her husband or some other trusted individual or institution as trustee. During the life of the owner and her spouse, the trustee is authorized to sprinkle income and principal among a class consisting of the owner's husband and descendants. Upon the death of the husband, the remaining trust assets are divided into shares for descendants and held in further trust. The owner's gifts to the SERT can qualify for the gift tax annual exclusion because the trust would include Crummey withdrawal powers for each of the owner's descendants. This removes value from the owner's estate. If desired, the owner could use the trust as a repository for a larger gift using her lifetime gift tax exemption, thereby freezing values for transfer-tax purposes. Moreover, the asset to be gifted to the trust can be interests in the closely held business, which a qualified appraiser may value by applying discounts for lack of control and lack of marketability, thereby achieving a discounting of asset values for transfer tax purposes.

Beyond being a good vehicle through which to achieve the wealth transfer trifecta of removing, freezing, and discounting values, the SERT provides a number of other benefits. The trust includes the grantor's spouse as a beneficiary. To avoid an argument that the trust should be included in the grantor's estate under Internal Revenue Code Section 2036, the grantor mustn't have any legal right to the assets held in the SERT, nor can there be any prearrangement or understanding between the grantor and her spouse that the grantor might use assets in the trust. Nonetheless, if the grantor is in a happy marriage, it can be comforting to know that her spouse will have access to the property in the trust even after the gift. As an additional benefit, the SERT would be established as a grantor trust for income tax purposes. As a result, the business owner would pay income tax on the income and gains earned by the trust. This depletes the owner's estate and enhances the value of the trust, but isn't treated as a taxable gift, in effect providing a very powerful additional means of removing value from the transfer tax system. Finally, the business owner could allocate her GST tax exemption to the SERT, thereby removing the gifted assets from the transfer tax system for multiple generations.

Additional popular wealth transfer strategies for business interests include the grantor retained annuity trust (GRAT) and the sale to an intentionally defective irrevocable trust (IDIT). The basic concept behind a GRAT is to allow the business owner to give stock in the business to a trust and retain a set annual payment (an annuity) from that property for a set period of years. At the end of that period of years, ownership of the property passes to the business owner's children or to trusts for their benefit. The value of owner's taxable gift is the value of the property contributed to the trust, less the value of her right to receive the annuity for the set period of years, which is valued using interest rate assumptions provided by the IRS each month pursuant to IRC Section 7520. If the GRAT is structured properly, the value of the business owner's retained annuity interest will be equal or nearly equal to the value of the property contributed to the trust, with the result that her taxable gift to the trust is zero or near zero. How does this benefit the business owner's children? If the stock contributed to the GRAT appreciates and/or produces income at exactly the same rate as that assumed by the IRS in valuing the owner's retained annuity payment, the children don't benefit because the property contributed to the trust will be just sufficient to pay the owner her annuity for the set period of years. However, if the stock contributed to the trust appreciates and/or produces income at a greater rate than that assumed by the IRS, there will be property "left over" in the trust at the end of the set period of years, and the children will receive that property - yet the business owner would have paid no gift tax on it. The GRAT is particularly popular for gifts of hard-to-value assets like closely held business interests because the risk of an additional taxable gift upon an audit of the gift can be minimized. If the value of the transferred stock is increased on audit, the GRAT can be drafted to provide that the size of the business owner's retained annuity payment is correspondingly increased, with the result that the taxable gift always stays near zero.

When we suggest a GRAT to a business owner, we nearly always invite her to compare the GRAT with its somewhat riskier cousin, the IDIT sale. The general IDIT sale concept is fairly simple. The business owner makes a gift to an irrevocable trust of, say, $100,000. Some time later, the business owner sells, say, $1 million worth of stock to the trust in return for the trust's promissory note. The note provides for interest only to be paid for a period of, say, 9 years. At the end of the 9th year, a balloon payment of principal is due. The interest rate on the note is set at the lowest rate permitted by the IRS regulations. There's no gift because the transaction is a sale of assets for Fair Market Value. There's no capital gains tax, either, because the sale is between a grantor and her own grantor trust, which is an ignored transaction under Revenue Ruling 85-13.

How does this benefit the business owner's children? If the property sold to the trust appreciates and/or produces income at exactly the same rate as the interest rate on the note, the children don't benefit, because the property contributed to the trust will be just sufficient to service the interest and principal payments on the note. However, if the property contributed to the trust appreciates and/or produces income at a greater rate than the interest rate on the note, there will be property left over in the trust at the end of the note, and the children will receive that property, gift tax-free. Economically, the GRAT and IDIT sale are very similar techniques. In both instances, the owner transfers assets to a trust in return for a stream of payments, hoping that the income and/or appreciation on the transferred property will outpace the rate of return needed to service the payments returned to the owner. Why, then, do some clients choose GRATs and others choose IDIT sales?

The GRAT is generally regarded as a more conservative technique than the IDIT sale. It doesn't present a risk of a taxable gift in the event the property is revalued on audit. In addition, it's a technique that's specifically sanctioned by IRC Section 2702. The IDIT sale, on the other hand, has no specific statute warranting the safety of the technique. The IDIT sale presents a risk of a taxable gift if the property is revalued on audit and there's even a small chance the IRS could successfully apply Section 2702 to assert that the taxable gift is the entire value of the property sold rather than merely the difference between the reported value and the audited value of the transferred stock. Moreover, if the trust to which assets are sold in the IDIT sale doesn't have sufficient assets of its own, the IRS could argue that the trust assets should be brought back into the grantor's estate at death under IRC Section 2036. Also, with a GRAT, if the transferred assets don't perform well, the GRAT simply returns all of its assets to the grantor and nothing has been lost other than the professional fees expended on the transaction. With the IDIT sale, on the other hand, if the transferred assets decline in value, the trust will need to use some of its other assets to repay the note, thereby returning assets to the grantor that she had previously gifted to the trust - a waste of gift tax exemption.

Although the IDIT sale is generally regarded as posing more valuation and tax risk than the GRAT, the GRAT presents more risk in at least one area, in that the grantor must survive the term of the GRAT for the GRAT to be successful; this isn't true of the IDIT sale. In addition, the IDIT sale is a far better technique for clients interested in generation skipping planning. The IDIT trust can be established as a dynasty trust that escapes estate and gift tax forever. Although somewhat of an oversimplification, the GRAT generally isn't a good vehicle through which to do generation skipping planning FN12.

As important as it may be for the business owner to understand the risks and benefits of a GRAT versus an IDIT sale, in our practice we've found that the primary driver of which technique to choose is cash flow. With an IDIT sale, the note can be structured such that the business owner receives only interest for a period of years, with a balloon payment of principal and no penalty for prepayment. This structure provides maximum flexibility for the business to make minimal distributions to the IDIT to satisfy note repayments when the business is having a difficult year and for the business to make larger distributions in better years. With the GRAT, on the other hand, the annuity payments to the owner must be structured so that the owner's principal is returned over the term of the GRAT, and only minimal backloading of payments is permitted. Accordingly, the GRAT tends to be the technique of choice where the business produces fairly predictable cash flow while the IDIT sale is chosen more often when cash flow is more erratic.

Additional Advanced Strategies

In addition to the estate planning strategies for family business owners that have already been discussed, there are a number of other estate planning strategies for family business owners that can be extremely effective in the right circumstance but are beyond the scope of a general overview. These include preferred partnership freezes (private annuities and self-cancelling installment notes (SCINs). The unique nature of particular industries, such as commercial real estate, can also require highly tailored estate planning strategies. While many of these advanced strategies require separate articles of their own, we can address a few here, including charitable planning strategies, the special issues presented by holding closely held business interests in trust, and postmortem planning.

1. Charitable planning.

Although lifetime charitable strategies, other than the charitable stock bailout, in which a charitable remainder trust is used to redeem the senior generations' shares in a tax-efficient manner, are typically not common in family business succession planning, testamentary charitable planning strategies can be among the most effective estate planning strategies for business owners who have done little or no lifetime planning.

Using what's known as the testamentary note-CLAT, this kind of planning can not only, under the right circumstances, keep the next generation of family members in control of the business, but also minimize or eliminate estate taxes and provide some amount for charity, even for a private foundation controlled by the business owner's family FN13.

A second highly effective testamentary strategy is known as a charitable lid. Although it can be structured in a variety of ways, basically a charitable lid is a planning technique that guarantees that if the IRS questions a valuation discount on an estate or gift tax audit and succeeds, the difference won't go to the IRS in the form of estate or gift tax, but rather to one or more charities named in the estate plan. This type of planning is thought to discourage the IRS from questioning valuation discounts, because even if the IRS succeeds, it won't collect any additional amounts since such amounts will pass to charity FN14.

2. Holding closely held business interests in trust.

Under the Uniform Prudent Investor Act, which has been adopted in most jurisdictions, trustees are required to diversify trust assets unless special circumstances or a specific direction justify not diversifying. Diversifying many times defeats the purpose behind most trusts holding family business interests - which is to preserve the business in the family. How do we protect trustees of trusts that hold concentrated positions in family businesses from surcharge liability for failure to diversify?

One way is to indemnify the trustee for failure to diversify out of the family business interests by specifically referencing the business in the trust instrument and instructing the trustee to continue to hold the stock unless certain specified events occur. These events could include continued poor performance of the business over a period of years or the consent of all or a supermajority of the beneficiaries.

If the trustee is still concerned, even with the protective language, it would be prudent to establish the trust as a directed trust in a state like Delaware. Under a directed trust, the trustee would serve primarily as an administrative trustee and a committee not involving the trustee (but likely including family members) handles investment issues regarding the family business.

3. Post-mortem planning.

Sometimes, the family business owner never gets around to doing effective liquidity planning. If that's the case, the tax code provides assistance by offering the ability under certain circumstances for the estate tax to be paid over a period of years to avoid a fire sale of the business to pay estate taxes. IRC Section 6161 allows a one-year hardship extension (renewable with IRS approval) for reasonable cause in the discretion of the IRS. IRC Section 6166 allows a 14-year extension if the business interest exceeds 35 percent of the decedent's adjusted gross estate. The first five years are interest only. Rigid rules accelerate the tax if there's a disposition of more than 50 percent of the value of the stock. An additional means of financing estate taxes is known as a "Graegin loan" in which the business owner's estate borrows funds needed to pay estate taxes on the business from a commercial lender - or, in an aggressive form of the technique, from a related entity - and deducts all of the interest on the loan in a lump sum on the estate's tax return FN15.

Executing the Plan

Estate and succession planning for family business owners can be very frustrating for both the business owner and her advisors. It's very complicated from both a family dynamics and estate-planning viewpoint. Unfortunately, it's made many times more difficult by the lack of collaboration among the advisors working on the estate and succession plan. It's not unusual for there to be a long-term entrenched advisor who's in over his head and threatened by the involvement of outside experts. This entrenched advisor can sometimes be more of an obstacle than a facilitator of the estate and succession plan, with drastic results for both the family business and the family itself. As Rousseau posited centuries ago, and John Nash, of A Beautiful Mind, proved mathematically, collaboration lifts all boats, including hopefully, that of the entrenched advisor.

David T. Leibell, Esq. is a Partner in the Private Client Services Department at Wiggin and Dana LLP. He focuses his practice on representing wealthy individuals and families, along with business succession and charitable planning. Mr. Leibell can be reached at +1.203.363.7623 or dleibell@wiggin.com.

Daniel L. Daniels, Esq. is a Partner in the Private Client Services Department at Wiggin and Dana LLP. He focuses his practice representing business owners, private equity and hedge fund founders, corporate executives and other wealthy individuals and their families. Mr. Daniels can be reached at +1.203.363.7665 or ddaniels@wiggin.com.

________________________________

Footnotes:

* This article was previously published in the June 2011 issue of Trust & Estates.

1 Family Firm Institute, Inc., Global Data Points, www.ffi.org/default.asp?id=398.

2 David Thayne Leibell, "Succession Planning," Trusts & Estates (March 2011) at p. 16.

3 If the recipient spouse is a non-U.S. citizen, the marital deduction is available only if the transfer is made to a qualified domestic trust for the benefit of the recipient spouse. Very generally speaking, a qualified domestic trust is a trust of which the recipient spouse is the only beneficiary and which has a United States resident trustee (which, in some cases, must be a United States bank). Internal Revenue Code Section 2056(d).

4 The generation skipping transfer (GST) tax exemption is indexed for inflation, with the result that the GST exemption in effect in 2013 will be somewhat more than $1 million. See "Dynasty Trusts," Daniel L. Daniels and David T. Leibell, Trusts & Estates April 2007, at p. 36.

5 See, e.g., Mellinger v. Commissioner, 112 T.C. 4 (1999), action on decision, 1999-006 (Aug. 30, 1999).

6 See "Laird Norton Tyee Family Business Survey, Family to Family, 2007," http://familybusinesssurvey.com/2007/pdfs/LNT_familybusinesssurvey_2007.pdf.

7 "A Practical Guide to Buy-Sell Agreements," David T. Leibell and Daniel L. Daniels, Trusts & Estates, March 2008 at p. 49.

8 Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968).

9 An S Corporation generally receives pass-through status as well, but can be less beneficial than a partnership or LLC at the death of the owner. Assets held inside a partnership or LLC can receive a stepped up cost basis if a proper election under Section 754 of the IRC is made. The Section 754 election isn't available for assets held inside an S Corporation.

10 In the view of some commentators, if the decedent makes a gift in a year when the gift tax exemption is $5 million but dies in a year in which the exemption is some lower amount, the estate will be taxed on the difference between the two exemptions. This is sometimes referred to as a "claw back" of the tax that "should have been" paid on the gifted asset. For a good discussion of this complex issue, see Evans, "Complications from Changes in the Exclusion," LISI Estate Planning Newsletter #1768 (Jan. 31, 2011) at www.leimbergservices.com.

11 In Revenue Ruling 93-12, 1993-7 I.R.B. 13 (Feb. 16, 1993), revoking Rev. Rul. 81-253, 1981-1 C.B. 187. the IRS ruled that gifts of separate minority interests in stock wouldn't be aggregated for purposes of determining whether a lack of control discount should be applied.

12 It's not possible to allocate GST exemption to a grantor retained annuity trust (GRAT) until the close of the estate tax inclusion period, which is the end of the GRAT term. By that time, most of the anticipated appreciation in value may have occurred, thereby preventing the leveraging of the owner's generation skipping exemption. IRC Section 2642(f)(1).

13 David T. Leibell and Daniel L. Daniels, "Never Can Say Goodbye," Trusts & Estates (October 2005) at p. 54.

14 Daniel L. Daniels and David T. Leibell, "Christiansen Is a Boon for Charities," Trusts & Estates (December 2009) at p. 14; "Charitable Lids Triumph Again," David Thayne Leibell, Trusts & Estates, Wealth Watch, http://trustsandestates.com/wealth_watch/charitable-lids-win-in-petter0120/.

15 See Daniel L. Daniels and David T. Leibell, "Post-Mortem Planning for the Closely Held Business Owner," ALI-ABA Audio Seminar, Oct. 29, 2008, www.ali-aba.org.

How Much Can You Gift

Thu, 08 Nov 2012 21:59:45 +0000

How Much Can You Gift

By: Martin Shenkman

Summary:

Everyone is talking about the importance of making big gifts in 2012, but the critical question for many, is how much can you realistically afford to gift without jeopardizing your own financial security? The question is complex and the right answer might be the wrong answer! Many clients are being completely misadvised in the name of an illusory "conservative" approach.

√ What are all of your personal goals? You cannot make a reasonable decision without laying all the cards on the table. Is assuring maximum resources for what hopefully will be many remaining years of retirement key? What are your ages and health status? What is the potential for a long joint life expectancy? What is really necessary to assure financial resources until the second of you dies (if you are married or have a partner)? So the prerequisites for those that are wealthy enough to plan, but not so wealthy that what remains will assuredly cover all future costs, are financial projections and simulations.

√ Some planners might suggest that you "run the numbers" assuming very low growth rates to be "conservative." But is that really the right answer? Using a consistent low investment return may even understate your performance if there is a market drop in early years of your projections. It might also so understate the anticipated return that it will preclude you from really achieving your gift and other goals. More sophisticated simulation models but better help you gain a level of comfort and identify a more robust gift plan.

√ Whatever projections are done life expectancy has been increasing, future inflation rates are difficult to predict, and possible health issues and the state of government and insurance programs to offset health care costs are a significant uncertainty. And since you've lived through the Great Recession investment risk must be a worry. But using worst case scenario projections won't protect you any better than going on a diet and use "very low" calorie estimates for the food you eat. It would be a fun diet but not very productive.

√ Some planners suggest running illustrations out to an old age like 100 years old, others suggest that if there is longevity in your family, run it out to 120. One well known planner suggests: "...run to some age that you think is well beyond the point you will actually live to, and show a high inflation rate and a low rate of return." That may eliminate the ability to make gifts when you can and should. Importantly it ignores the tremendous flexibility trust drafting can provide. You might gift a gift to a self settled trust of which you, your spouse and all descendants are beneficiaries. So if you can receive distributions if needed. Your spouse or partner might fund another trust that names you and descendants as beneficiaries. One of the assets you might gift to the trust might be a closely held business from which you will continue to draw a salary.

√ Excessively conservative financial projections will be damaging to making gifts. Perhaps a more sophisticated approach can achieve more objectives: facilitate maximizing gifts, deflecting any fraudulent conveyance claims by creditors (e.g., you gave away too much as to render yourself insolvent), rebutting an IRS challenge that you had to have an understanding with the donee's to give you money back since you did not retain sufficient assets, all while assuring your financial security. What approach may achieve all these goals? Perhaps use a budget and investment projection and model a result that gives you an 80% probability of achieving your financial goals. Then gift sufficient funds into a self settled trust (domestic asset protection trust or DAPT) to assure a much higher probability of achieving your financial goals. The excess over that can be given to a dynastic trust that you are not a beneficiary of. Making unreasonably "conservative" financial projections ignoring the nature of the done trusts that can be used in your plan is actually not conservative but dangerous to your taking the optimal planning steps for you.

√ The core of the above decision must be a budget and financial plan that assures that both of you, the resources you need for your future, from whatever sources. Intelligent financial planning must lead the estate plan. You cannot gift completely away in any format assets that the financial plan determines are essential for your financial needs. You can gift away assets to your children or trusts for them that the financial plan demonstrates you will never need. Some amount of wealth, perhaps unlikely to be needed by you, but which might be needed by you, should be structured in a manner that permits you access to it "just in case" you should need it.

Additional Info:

Martin Shenkman, Jonathan Blattmachr, and Robert S. Keebler just published a 200 page book entitled, "2012 Estate Planning: Tax Planning Steps to Take Now." It is now available as an ebook on www.amazon.com for $39.95 and is written for both the sophisticated client and professional adviser.

RECIPROCAL SLATS

Thu, 08 Nov 2012 20:58:22 +0000

RECIPROCAL SLATS

By: Julius Giarmarco, J.D., LL.M.

The once-in-a-lifetime opportunity to gift $5.12 million without gift or generation-skipping transfer (GST) tax will - without further Congressional action - expire on December 31, 2012. On January 1, 2013, the gift tax exemption will revert to $1 million and the top tax rate will revert to 55%.

While many high net worth married couples might like to take advantage of their $5.12 million gift tax exemptions, they may be reluctant to do so because of lost access to the gifted property's income and principal. One strategy to keep the gifted income and principal within reach is a Spousal Lifetime Access Trust ("SLAT"). In simple terms, a SLAT is an irrevocable trust set up by one spouse for the benefit of the other spouse.

Example.

For example, assume husband ("grantor-spouse") creates a SLAT for the benefit of wife ("beneficiary-spouse") and funds it with his $5.12 million gift tax exemption. During wife's lifetime, the Trustee (which may be wife) can distribute to wife income and principal as needed for her health, education, maintenance and support. Wife can also be given the power to withdraw the greater of $5,000 or 5% of the trust principal annually, and a testamentary limited power of appointment to "rewrite" the trust upon her death. Thus, through wife, husband retains "indirect" access to the SLAT's income and principal.

When wife passes away, the unappointed trust property (including appreciation) passes - estate tax free - to the children and, depending on state law, even more remote descendants (if husband allocated his generation-skipping tax exemption to the SLAT gift). An added benefit of a SLAT is that it protects the beneficiaries from creditors, including ex-spouses.

Grantor Trust Status.

For income tax purposes, the SLAT is a grantor trust for the lifetime of the grantor-spouse. Thus, in the above example, husband reports the SLAT's income and capital gains on his personal tax return. Payment of the SLAT's income taxes allows the SLAT to compound "tax free". Such payments are essentially a tax-free gift to the beneficiaries of the SLAT. To provide the cash to pay the taxes, if necessary, the SLAT can give an independent trustee the discretion to reimburse the grantor-spouse for any taxes paid.

Hedging the Bet with an ILIT.

One obvious problem in the above example is that, upon wife's death, husband loses his indirect access to the trust's income and principal. One simple solution is for wife to create an irrevocable life insurance trust ("ILIT") for the benefit of husband. The ILIT would be funded with a life insurance policy on wife's life to "replace" the wealth lost to husband at wife's death. If necessary, the SLAT can loan the ILIT the funds needed to pay premiums under a split-dollar arrangement.

Avoiding the Reciprocal Trust Doctrine.

Can each spouse create a SLAT for the benefit of his/her spouse so as to increase the gift to $10.24 million? It's possible, but the IRS could unwind the transactions under the reciprocal trust doctrine. If applicable, each spouse will be treated as having established a trust for his/her own benefit, resulting in estate inclusion of each spouse's "own" trust at his/her death.

However, if the trusts are significantly different from each other, the reciprocal trust doctrine will not apply. There is no "safe harbor" as to what constitutes a sufficient difference between two trusts to avoid the reciprocal trust doctrine. Therefore, the best approach is to make the trusts so different that the spouses are not in the same economic position after the trusts are created. Following are ways SLATs may be drafted to differ from one another:

1. Income. In one SLAT, provide that the beneficiary-spouse is the sole income beneficiary; and, in the other SLAT, allow income to be "sprinkled" among the beneficiary-spouse and the couple's descendants. Further, in one SLAT, allow income to be accumulated; and, in the other SLAT, require all of the income to be distributed annually.

2. Principal. In one SLAT, allow principal to be "sprinkled" among the beneficiary-spouse and the couple's descendants; and, in the other SLAT, make the beneficiary-spouse the sole principal beneficiary. Further, in one SLAT, allow distributions to the beneficiary-spouse (acting as sole trustee) for health, education, maintenance and support (HEMS) only; and, in the other SLAT, allow an independent trustee to make distributions to the beneficiary-spouse for HEMS, as well as "best interests". Finally, in one SLAT, give the beneficiary-spouse an annual $5,000/5% withdrawal power; but not in the other.

3. Limited Powers of Appointment. In one SLAT, give the beneficiary-spouse a testamentary limited power of appointment (LPA) to "rewrite" the trust; but not in the other. Or, in one SLAT, give the beneficiary-spouse the broadest LPA possible (i.e., anyone other than the beneficiary-spouse, his/her estate, his/her creditors or the creditors of his/her estate); and, in the other SLAT, limit the potential appointees to the grantor-spouse's descendants and charity. Further, in one SLAT, allow the LPA to be exercised during lifetime; and, in the other, SLAT only at death.

4. Final Takers. In the event no descendants are surviving, use different remote contingent beneficiaries in each SLAT (i.e., siblings, nieces, nephews, charities, etc.).

5. Trustees. In one SLAT, have the beneficiary-spouse act as the sole trustee; and, in the other SLAT, have the beneficiary-spouse serve as co-trustee with a third party (which may be a child). In one SLAT, allow the grantor-spouse to remove and replace trustees; and, in the other SLAT, allow the beneficiary-spouse to remove and replace trustees.

6. Assets. Fund one SLAT with liquid assets (i.e., cash, marketable securities, bonds, etc.); and the other with illiquid assets (i.e., real estate, closely-held business interests, etc.).

7. Timing. Separate the creation and funding of the two SLATs by at least one to three months.

Summary.

SLATs, like many other estate planning techniques, have some drawbacks. Access to trust assets is available only to the grantor's spouse (and/or other beneficiaries) - not to the grantor. Thus, the grantor only has "indirect" access to the trust property through his/her spouse. Therefore, divorce or the death of the beneficiary-spouse will eliminate this limited access. But, as mentioned above, the loss of access caused by the death of the beneficiary-spouse can be "remedied" by an ILIT. And divorce can be "covered" by allowing the trustee to loan money to the grantor-spouse without security and at below market interest rates. Finally, the SLAT must be carefully drafted to avoid inadvertent estate tax inclusion - particularly if reciprocal SLATs are established. In summary, SLATs will be attractive to many high net worth couples looking to maximize their $5.12 million gift tax exemptions, while retaining some access to the gifted assets.

The 60/40 CLAT

Tue, 06 Nov 2012 17:08:23 +0000

THE 60/40 CLAT

By: Salvatore J. LaMendola, Esq.

Introduction

Despite their impressive achievements, many successful business owners still experience a lack of accomplishment. This might have been best expressed recently by John Caudwell, a 58-year-old U.K. billionaire, as follows: "It's partly a question of what you want to see on your tombstone. Here Lies a Very Successful Businessman doesn't really do it, does it? FN1" Caudwell is giving much of his wealth away to help disabled children around the world. Business owners who, like Caudwell, would like to share their good fortune with others, but who also would like to pass on their businesses to their heirs estate tax free should consider a "60/40 CLAT". What that is, how it works, and how it helps closely-held business owners are all discussed below.

1. What is a CLAT?

A charitable lead annuity trust (CLAT) is an irrevocable trust that first pays an annuity to one or more charities for a term of years. Then it pays its remaining assets to the settlor's children (or other heirs). These are called the "remainder beneficiaries" or the "remainder interest." The payments to charity are called the "lead interest." The present value of the lead interest is deductible for gift tax purposes.

Example 1:

Al and Susan would like to make a $1,000,000 gift to their children. Susan sets up a $1,000,000 CLAT that pays $55,415 to charity for 20 years. In year 21, the trust pays what's left to the children. Assuming a 1% IRS discount rate, the lead interest is worth $1,000,000. Thus, on her gift tax return, Susan reports a $1,000,000 gift and a $1,000,000 charitable deduction. After subtracting, Susan reports a $0 taxable gift. This type of CLAT is called a "zeroed-out" CLAT because of the zero taxable gift that it produces.

2. Is the lead interest also income tax-deductible?

That depends on the trust's income tax classification. If a "grantor trust" (making the trust a "grantor CLAT"), the settlor can deduct the lead interest against his income. However, he must also include the trust's income on his own income tax return (and pay tax on the same). As discussed further below, paying tax on such "phantom income" is not necessarily a bad idea.

Example 2:

Assume the same facts as in Example 1 above and also that the CLAT is a grantor CLAT. In that case, Susan can also deduct $1,000,000 against her income in the year of the gift. If the $1,000,000 deduction exceeds 30% of her AGI for that year (20% if the charity is a private foundation and the gift asset is capital gain property), Susan can deduct the excess against her future income in up to 5 succeeding tax years. In addition, for each year of the 20-year CLAT term, Susan must pay income tax on all income earned by the trust. (She does not get to deduct the $55,415 that the CLAT pays to charity each year because that was already deducted when she set up the trust.)

3. What additional wealth transfer advantages does a grantor CLAT provide?

On top of the gift and income tax deductions for the lead interest, a grantor CLAT also provides the following advantages: (i) the settlor's payment of income tax on phantom income is effectively a tax-free gift to the remainder beneficiaries; and (ii) grantor trust status partially "opens the door" to using CLATs with closely-held business interests, such as S-corporations and LLCs.

4. What is a 60/40 CLAT?

A 60/40 CLAT is a grantor CLAT with a lead interest equal to 60% of the gift asset and with a remainder interest equal to 40% of the gift asset.

Example 3:

Assume the same facts as in Example 2 above, except that Susan opts for a 60/40 CLAT (with a 12 year term). On her gift tax return, Susan again reports a $1,000,000 gift, but now a $600,000 charitable deduction. After subtracting, she reports a taxable gift of $400,000. Susan pays no gift tax, however, because her $5,120,000 gift tax exemption (2012) is more than enough to cover the taxable gift.

5. What is the wealth transfer advantage of a 60/40 CLAT?

The 60/40 design "opens the door" to using grantor CLATs with closely-held business interests "the rest of the way." This is because the 60/40 design allows the trust to hold the business interest for longer than 5 years. This, in turn, allows a more reasonable annuity payment FN2. Increase the lead interest to 61% or more, and the trust must sell the business interest to non-family members (or back to the business itself) within 5 years of receiving it.

Example 4:

Assume the same facts as in Example 3 above except that the $1,000,000 gift asset is stock in an S-corporation. Because the trust's lead interest does not exceed 60%, the trustee can hold the stock for the full 12 year term, still paying $55,415 to charity each year.

6. Why is the 60/40 CLAT especially important now?

With interest rates at all-time lows and the gift tax exemption at an all-time high, one can hardly think of a better time than now for business owners to use 60/40 CLATs in their planning. Based on the 2012 exemption, Table 1 below shows the maximum value that can be transferred with a 60/40 CLAT gift tax free.

Table 1

Marital Status Maximum Value

Single $12,800,000

Married $25,600,000

7. What about valuation discounts?

Valuation discounts add further leverage, allowing even more to be transferred gift tax free. Assuming a gift by a married couple in 2012, Table 2 below illustrates the maximum value that can be transferred with a 60/40 CLAT at various discount rates.

Table 2

Discount Rate Maximum Value Annuity Payment(FN3) Term(FN4)

10% $28,444,444 $1,422,222 11

20% $32,000,000 $1,600,000 10
30% $36,571,429 $1,828,571 8
40% $42,666,667 $2,133,333 7
50% $51,200,000 $2,560,000 6

Example 5:

Instead of transferring just $1,000,000 of S-corporation stock, Al and Susan would like to transfer as much of their stock as possible to their children in 2012. They therefore recapitalize their corporation into voting and non-voting shares. The non-voting shares (99% of the equity) appraise for $36,571,429 (pre-discount) and for $25,600,000 after a 30% valuation discount is applied. After subtracting the 60% lead interest (60% x $25,600,000 = $15,360,000) the taxable gift is $10,240,000 ($25,600,000 - $15,360,000). Though only Susan is the settlor of the trust, the couple pays no gift tax because they elect to "split" the gift. This means that each spouse is treated as having made one-half of the gift, thereby using both of their $5,120,000 gift tax exemptions ($10,240,000 total).

8. What advantages does a 60/40 CLAT have over other business transfer techniques?

Table 3 below provides some points of comparison between the 60/40 CLAT, a GRAT, and sale to an IDGT.

Table 3

GRAT IDGT 60/40 CLAT

Mortality Risk? Yes No No

Tax on "Phantom Income?" Yes Yes Yes
Income Tax Deduction? No No Yes
Estate Tax on GRAT Annuity/ Yes Yes n/a
IDGT Note?
Gift to Charity? No No Yes

9. What are some options on the charitable end?

Recipients of the 60/40 CLAT payments can be the settlor's favorite charities or a donor advised fund. The latter is generally preferable because it allows the settlor (and then later generations) to select which charities ultimately benefit.

10. What are some disadvantages of the 60/40 CLAT?

First, a 60/40 CLAT does not make efficient use of the generation skipping tax exemption. If such is desired, a 60/40 CLUT (charitable lead unitrust) could be used. Table 4 below is the same as Table 2 above, except that Table 4 applies to 60/40 CLUTs. Note that the only difference between the two tables is in the "Term" column (slightly longer for 60/40 CLUTs).

Table 4

Valuation Discount Maximum Value Unitrust Payment(FN5) Term
10% $28,444,444 $1,422,222 16
20% $32,000,000 $1,600,000 14
30% $36,571,429 $1,828,571 12
40% $42,666,667 $2,133,333 10
50% $51,200,000 $2,560,000 8

Second, whether a 60/40 CLAT or CLUT, if the settlor dies before the term, the income tax deduction must be partially recaptured in the form of taxable income to the settlor's estate.

Conclusion

Zeroed-out grantor CLATs warrant serious consideration in all wealth transfer planning contexts FN6. But for owners of closely-held business interests, the 60/40 CLAT may be the best way yet to choose children and charity over Congress.

________________________________

1 Jon Henley, The New Philanthropists, The Guardian, (March 7, 2012) http://www.guardian.co.uk/society/2012/mar/07/new-philanthropists-wealthy-people? INTCMP=SRCH.

2 For example, using a 5-year "zeroed-out" CLAT to transfer a $1,000,000 closely-held business interest would require a $206,040 annual payment to charity. In contrast, the 20-year zeroed-out CLAT in Example 1 above required only a $55,415 payment per year.

3 5% of Maximum Value shown at left. As expressed in the trust instrument, the payment rate would be "grossed up" to reflect the valuation discount.

4 Rounded down.

5 First year unitrust payment equal to 5% of Maximum Value shown at left. Subsequent years' payments will vary with trust growth or shrinkage.

6 In fact, a recent study by a leading financial firm demonstrated how a 20-year zeroed-out grantor CLAT funded with $10,000,000 delivers as much wealth to children as a GRAT and more wealth to children than a sale to an IDGT, without factoring in the $10,000,000 income tax deduction. See Paul S. Lee, J.D., LL.M., National Managing Director Bernstein Global Wealth Management, Innovative CLAT Structures: Providing Economic Efficiencies to a Wealth Transfer Workhorse, ALI-ABA Course of Study, Advanced Estate Planning Techniques, March 24-25, 2011, San Francisco, California, pp. 13-15.

World's Ugliest 2012 Gift Plan

Tue, 06 Nov 2012 16:05:56 +0000

World's Ugliest 2012 Gift Plan

By: Martin Shenkman

Summary: You might have seen worse, but this baby is up there. And, just like Ripley's Believe it or Not! Where "Truth is stranger than fiction," this plan was a real one. Fortunately the taxpayer appears to have been saved from disaster, but their "plan" is a great checklist of everything you don't want to do in your 2012 gift plan. While some of the items below individually could undermine the success of a gift plan, the advisers who created this winner chose to really assure as many bad facts as possible to maximize the likelihood of failure (or at least it seems so).

Form a New LLC:

This client had a limited liability company (LLC) that had been around for years, yet the advisers set up a brand new LLC to use for the gifts. If you don't have an LLC (or other suitable entity) and using an entity makes sense in your transaction, then setting up a new one is the only alternative. But setting up a new entity instead of using an existing entity will only heighten tax and asset protection risks. While the old and cold entity might have an clear business purpose, will the newly formed entity? Elsie J. Church v. US. Gifts of non-controlling interests in LLCs can qualify for valuation discounts (i.e., the value of a 20% interest in the LLC is less than 20% of the value of the underlying assets). While 20% of an LLC is worth something less than 20% of say the securities portfolio the LLC owns, securities are worth their actual value. The LLC interest may be discounted because a 20% owner cannot control the vote, distributions, etc. Using a long existing LLC, in the view of some advisers, may be more secure. If you have an asset like an operating business or rental property you certainly want it held in its own LLC to protect your other assets from a lawsuit that business or property might create. But if you have an existing investment LLC setting up a duplicative new one will only increase the costs and complexity. Good for the lawyers but not for you.

Transfer assets into the LLC 2 Days before Making Gifts:

Say you want to put assets into and LLC and then gift non-controlling LLC interests to trusts. Those non-controlling interests should be valued at a discount from the underlying asset value (see above). However, if you plop assets into the LLC just prior to the gift, the IRS will say that the gift was really of the underlying assets and that the LLC "envelope" holding those gifts should be disregarded. Shepherd v. Comr. Poof! Your hoped for discount disappears. Just like a fine wine, assets must appropriately aged to develop the discount bouquet. Two days barely makes vinegar.

Have Documents Notarized in Different States:

So you're in State A and sign your documents, but your lawyer has a notary in State B notarize a key transfer document. Hmmmmm, absent a little "Beam me up, Scotty" transporter action that just doesn't seem possible. The IRS or a creditor might raise an eyebrow as to the validity of the document and trash the entire transaction as invalid. Estate of Senda.

Put Personal Use Assets in the LLC:

If an LLC is supposed to be respected as a legitimate business and investment entity it should not own personal use assets. Putting your house into an LLC and continuing to live there without paying rent will torpedo your plan faster than you can say "Supercalifragilisticexpialidocious." Reichardt v. Commr. Well, a residence used by your family member free of rent might differ from the facts in the Reichardt case since it's not you, but free family use of personal property will torpedo the LLC just the same.

Have Lots of Back and Forth Unsubstantiated Loans:

Undocumented loans between the LLC and members and other family entities might be recharacterized as equity, compensation, gift transfers, etc. depending on the circumstances. Miller v. Comr. But an excessive amount of undocumented loans might jeopardize the integrity of the LLC.

Leave the Donor Cash Poor:

If you're left with inadequate assets after the transfer to the LLC to support yourself the transfer could be deemed a fraudulent conveyance or indicative that the LLC could not be valid as you would have to be able to retrieve cash from it to survive. In our worst case scenario the taxpayer was left with a mere $3,500 in cash in his name. That fact alone would likely torpedo the gift plan. Estate of Harper; Estate of Reichardt; Estate of Schauerhamer.

Don't Get an Appraisal:

Although four months after the purported transaction was completed the lawyer wrote the clients suggesting they obtain an appraisal of the LLC interests given. Consummating a $5 million gift without a formal appraisal of the LLC interests is certainly inadvisable. While in the recent Wandry case the appraisal was completed after the gift the transfer documents clearly limited the dollar amount specified and there was a commitment to obtain a qualified appraisal. Winging it just isn't sensible and gives no protection in the event of an audit.

Don't Sign Appropriate Post Gift Documentation:

If you gift away 80% of an LLC, there should be a post gift operating agreement signed by all the owners and confirming the ownership percentages. In this worst case scenario nothing was done for more than a year after the assignments were executed. No current operating agreement.

Be Sure the Donor Didn't Understand the Transaction:

The IRS has taken a liking to asking taxpayers to explain the transactions they were involved in. If the taxpayer had no clue the deal was done, what was done, how or why, you may as well just start praying that the taxpayer is not questioned by the IRS, or the plan will assuredly flop.

Use Effective Dates and No Real Execution Date:

Proper execution of documents to assure their effectiveness is important. Proper dating of documents to assure that the sequence of events occurred as appropriate, and that there was sufficient time between different steps of the transactions (whatever those time frames might be) is vital. If your attorney prepares key documents signed listing an effective date, but no date for the actual signature, you cannot demonstrate what time frames actually existed between the steps or the order in which the different steps in the transaction actually occurred.

Pay Personal Expenses from the LLC:

Paying personal expenses from a family entity is contrary to respecting the entity for tax and legal purposes. If practices were lax, clean them up before any transfer is made.

Don't Open an LLC Bank Account:

Without the fundamental business formality of a bank account how can the LLC pay its own bills? How can it possibly look real?

Don't Use a Defined Value Clause:

In the wake of the Wandry case, some advisers are suggesting a more frequent use of a defined value clause that establishes a gift of an intended dollar value of LLC interests rather than a percentage of LLC interests. When gifts are made of hard to value assets like LLC interests that may be discounted, especially when the LLC owns minority interests in other entities that hold hard to value real estate assets, and when you're pushing up to the line of your $5.12 million gift exemption, some type of safety valve, like a Wandry defined value clause should at minimum be discussed and considered.

Show LLC Assets on the Donor's Balance Sheet:

If you want to convince the IRS that the LLC is, in the words of Dr. Phil, the "real deal" you really should consider separate LLC financial statements, but you absolutely don't want to show your pro-rata share of underlying LLC assets on your balance sheet. That is tantamount to your almost corroborating to the IRS that there are no discounts because the gift was of underlying assets, not discountable LLC membership interests.

Don't Use Independent Professionals:

Have the CPA prepare all tax returns, determine the value of the entity interest given, use the CPA's wife as a witness, have the same CPA serve as the sole trustee of the donee trusts, don't have anyone represented by independent counsel, etc.

Believed Client was on Deathbed:

The IRS has long frowned on deathbed gifts. But documenting in an email that you believe the client was near death as the rationale for the plan is really over the top. At least make the IRS auditor earn his or her keep!

No Documentation of Capacity:

One statistic suggests that 50% of those over age 85 have some degree of cognitive impairment. If you're dealing with a donor in her late 80s should you at least have counsel corroborate that the donor had adequate capacity to sign the relevant gift and other documents? Also bear in mind that contractual capacity may be required to execute an operating agreement, assignments, trust and other documents. This is a greater level of capacity then testamentary capacity which will suffice to sign a will.

Additional Info:

Skyfall 2012- Maximizing Year-End Gift Planning

Wed, 31 Oct 2012 20:07:05 +0000

Skyfall 2012

Maximizing Year-End Gift Planning

By: Robert L. Moshman, Esq.

Felix Baumgartner jumping from space

Alert! The sky may be falling (again)!

This is the time of year when Earth passes through the tail of Halley's Comet and the annual Orionid meteor shower provides a spectacular show of falling stars. This year's show has some people mixed in with the meteors, i.e., James Bond is falling in Skyfall, and Felix Baumgartner accomplished a free fall from 24 miles high.

"The sky is falling!" is also what people say whenever the "Bush tax cuts" are about to expire. It has become a combination of Cinderella and Ground Hog Day. Our federal tax code may turn into a pumpkin at midnight at year's end by reverting to 2001 levels, and Congress has us reliving this crazy scenario over and over.

Let's look at year-end planning for this unique time.

3, 2, 1, Jump!

The view from 24 miles high is spectacular, and the prospect of breaking many records on the world's stage is alluring; however, placed in those circumstances, some of us might have told the world, "I've changed my mind about this jumping thing."

To jump from that height is literally a leap of faith. But consider the planning that leads to such a bold step. It is not a spontaneous decision based on a newly discovered opportunity; rather, it involves careful planning over a long period of time--with test jumps and attention to every detail--so that the results can be nearly certain.

Felix Baumgartner's jump represented extensive preparation. A 55-story helium balloon was needed to bring his capsule to the stratosphere, and a special space suit was required to withstand falling at 833 miles per hour.

Baumgartner broke the sound barrier. He broke the free fall height record. He broke the record for the highest manned balloon flight. He broke all kinds of jumping-from-space-type records.

The space jump was also a singular cultural moment. A record number of more than 8 million people watched concurrent live streams of the event on YouTube. The Twitterverse went into some kind of Tweeting frenzy, and Baumgartner's post-jump photo on Facebook got 216,000 "likes" within 40 minutes--demonstrating that the modern world is both amazing and annoying.

Note, however, that with a classy, old-fashioned nod, Baumgartner purposely popped his parachute at the 4-minute, 20-second mark so that he would NOT break the record for the longest free fall. The existing record of 4 minutes 36 seconds was set by Joe Kittenger in 1960 when he jumped from about 20 miles high. Kittenger, now age 84, had been assisting Baumgartner as the capsule communicator in the Red Bull Stratos project.

In all, Baumgartner spent more than five years of planning before his jump took place.

3, 2, 1, Gift!

As 2012 draws to a close, and our recurring "sky is falling" scenario of the automatic reversion to 2001 estate and gift tax rules is almost upon us, many people are contemplating whether they should take advantage of the current $5.12 million gift tax exemption before it expires. The gift tax exemption is scheduled to return to $1 million in 2013.

Estate planners are experiencing what it is like to suggest that clients consider giving away significant portions of their estate before the $5.12 million gift tax exemption expires. Some possible responses from clients:

"Say again?"

"Give away HOW much?!"

"You're fired."

A fleeting opportunity to minimize estate tax savings may be more appealing to estate planning professionals than to clients who are offered the chance to give away their assets.

For many people, those assets are difficult to part with because they were hard to come by over the course of a lifetime. Sacrifices were made to keep them. Watching them diminish in bad markets in recent years has been an ordeal. So it is not easy to embrace the concept of giving assets away on short notice. This is especially true when the motivating factor is not based on a firm and reliable tax code system with known rules but, rather, on the expiration of one favorable set of rules and the uncertainty of what may follow.

Give assets away and jump into a void? Some people would rather jump from the Red Bull Stratos capsule and plummet 128,000 feet. Which has the more certain outcome at this point?

Making a significant year-end gift in 2012 may be a lot easier for someone who is extremely wealthy. It is easier to justify giving away 10% of your assets than 50%. Making a significant gift is also easier if the donor is retaining sufficient assets to maintain the same lifestyle, income, and control over business interests.

However, logic may not enter into every situation. For example, Donor M, age 85, was finally convinced to set up an irrevocable trust for his grandchildren so that some of his assets could be moved out of his estate for transfer tax purposes, as well as for pre-Medicaid qualification purposes. The trust was set up. Some assets were moved into the trust.

But, at the last minute, Donor M refused to transfer $500,000 of assets. The reason? He wanted to be able to directly control how the assets were invested. It did not matter that the trustees would do exactly as Donor M told them. It did not matter that the assets in question were in long-term municipal bonds that Donor M never reinvested anyway. Having an irrelevant level of control was more important to Donor M than reducing future transfer tax liabilities.

Pondering Gifting Outcomes

What level of tax savings are at stake with a year-end gift in 2012? Must the gift be $5.12 million to obtain the full advantage? Or should a wealthy married couple transfer $10.24 million collectively?

Example #1: If all the stars were aligned for a grantor in 2012 and $5.12 million was given before year's end with 1) no prior gifts having been given; 2) a reversion in 2013 to the $1 million exemption for gifts and estates; 3) no "claw back" recapture of taxes saved by the 2012 gift; 4) no subsequent increase in the estate tax exemption before the grantor's death; 5) no use of annual gift tax exclusions or other estate planning techniques; and 6) an applicable tax rate of 55% based on the grantor's taxable estate, then the net outcome would be the exposure of $4.12 million of funds (assuming no appreciation or depreciation from those funds) to a tax rate of 55%.

So a maximum gift in 2012, with all conditions being exactly right, could have a maximum savings of $2,266,000.

Example #2: Now let's change the assumptions so that the ultimate exemption turns out to be $3.5 million with a top estate tax rate of 35%, i.e., one of the more plausible scenarios. If the grantor maximized his 2012 gift, an extra $1.62 million would be transferred and would avoid a 35% estate tax, saving $567,000.

A number of other benefits apply:

Transferred assets continue to generate income that is taxed to a beneficiary who is in a lower income tax bracket.

There is an additional appreciation of value on the gifted assets that is also excluded from the donor's estate.

This gift can also be given to grandchildren and can qualify for the generation skipping transfer tax exemption for 2012.

The gift can be part of an FLP and Family Trust that provides asset protection benefits.

Example #3: Here is another example with more realistic conditions. The grantor has a more modest estate and makes a 2012 gift of $3 million. The estate and gift tax exemption reverts briefly to $1 million, but Congress ultimately sets the exemption at $2 million and keeps the estate tax capped at 35%. In this scenario, the grantor would be able to gift $3 million instead of the ultimate limit of $2 million. His extra $1 million gift would avoid estate tax of 35% or $350,000.

Example #4: The grantor hears what he wants to hear about the gift tax exemption expiring at the end of 2012 and gifts $2 million before year's end. The gift tax reverts to $1 million. For argument's sake, let's assume that Congress breaks up the gift and estate tax credit again and has a $3.5 million estate tax exemption, even though the lifetime gift tax exemption remains at $1 million. In this scenario, the grantor would have hedged his bets a bit. He would have given away more during his lifetime than the ultimate limit but would not have been prejudiced entirely by holding his assets due to the ultimate estate tax exemption.

Donor's Remorse

What could go wrong with an accelerated gift?

Opportunities may be lost for the donor who could have invested funds that were transferred. Once funds are distributed among various beneficiaries, they may not be conserved and invested effectively and may simply be spent.

Transferred assets may be wasted by the beneficiaries, exposed to creditors, split up during divorces, and eroded away.

Appreciated assets that are transferred may subsequently trigger capital gains instead of being transferred with a stepped-up basis at death.

A donor at 72 may greatly underestimate his life expectancy; upon living to 92, he may wish he had some of that money he gave away in 2012.

A Contrarian's Summation

Is Congress so deadlocked and the nation is so debt ridden that the $5.12 million estate and gift tax exemption will revert to $1 million or stay there permanently? That argument simply doesn't convince every estate planner or client.

Congress intervened the last time we were threatened with the reversion to 2001 and not only prevented the reversion but actually increased the exemption significantly from the pre-estate tax repeal plateau of $3.5 million up to $5 million in 2011 and $5.12 million in 2012. And Congress didn't stop there. It provided a major innovation in the portability of spousal exemptions, making it possible for married couples to take full advantage of both spouses' exemptions by conserving the exemption of the first spouse to die.

A-B Trust Planning: Let's linger on that point for just a moment. A couple had previously been able to exploit the exemptions of both spouses by incorporating two trust plans into an estate that would apply the marital deduction to a portion of the estate that was transferred to a marital or qualified terminable interest property (QTIP) trust, aka "A" trust, and then apply the deceased spouse's lifetime exemption to a second trust, a bypass trust or credit shelter trust, aka "B" trust.

With the advent of the portability clause, Congress made it possible to just leave the entire estate to the surviving spouse and have that spouse utilize the cumulative exemptions at death. This assumes, of course, that the married couple has identical beneficiaries. If there are children from previous marriages, trust planning remains important. Trusts also remain relevant for asset protection.

Does this sound like the plan of a Congress that would now go back to a $1 million exemption that is not portable? Could Congress fail to act and have the Bush tax cuts expire automatically? Yes. A dysfunctional Congress could get into an immense brawl (figuratively or perhaps even literally) that distracts them, while the estate and gift tax exemption reverts to 2001 levels.

However, realistically, it is hard to imagine such a reversion remaining the law of the land for very long. Members of Congress, their families, their constituents, and their donors all have estates and know when their ox is being gored. The more likely adjustment to the transfer tax system would be to reset the exemption at $2 million or $3.5 million and retain the portability feature.

An Unconventional End Game

Conventional year-end financial planning may not fit every person's circumstances this year. The reason is that 2013 could bring higher federal, state, and local taxes. The composition of the Federal Congress is changing, but even knowing the outcome and proposals cannot help fully anticipate the potential deals or gridlocks that will affect tax rates or deductions.

Based on revenue constraints, the default setting of the Bush tax cuts expiring, and the new health care law surtaxes, one can anticipate higher tax rates in 2013 while deductions would be cut back. If this holds true, then several strategies would follow:

Normally, those who can control the timing of when they receive income generally defer income so that it is taxed in the following year. With higher taxes coming next year (potentially), the reverse would be true and income should be accelerated to 2012. This may also make sense based on the security of the source of income. These days, one should seize his or her income before sources run out of funds.

Bunching deductions to meet the 25%-of-income threshold continues to be a useful strategy. Deferring deductions to next year could be risky if the particular deductions are those that could be eliminated. For higher income taxpayers, itemized deductions and personal exemptions could be phased out in 2013, making them more valuable in 2012. On the other hand, if income is accelerated to 2012 and next year's income and the 2% threshold is lower, that may be a better time to utilize deductions.

Aside from the lifetime gift tax exemption, there is the annual gift tax exclusion, in which every donor can make annual gifts to an unlimited number of donees. For 2012, the exclusion is $13,000. With gift splitting, a husband and wife can give $26,000 to every donee. That works out to about $52,000 to each child and his or her spouse. So if a couple has two married children who each have two children, an annual gift program to all eight donees can transfer $208,000 every year, free of gift tax. Over 10 years, that amounts to more than $2 million. Set up properly in a trust with Crummey powers, life insurance purchasing designs, and other planning techniques, simple annual gifting can provide a powerhouse of planning without incurring transfer tax liabilities.

Capital gains have been an endangered species for the last few years; when one has any actual gains, realizing them by selling that asset almost feels like shooting the last white rhino. But taking a gain also provides an opportunity to sell off a bad investment and neutralize the gain.

Capital gains might be better taken in 2012, even if there aren't offsetting losses because of higher tax rates on capital gains that would apply starting in 2013. The anticipated rate would be a return from 15% to 20%. For those who want to retain certain investments, it is possible to sell the position in 2012 and wait 30 days prior to repurchasing the security to comply with "wash sale" rules.

Businesses set up as C and S corporations that pay dividends, which are currently taxed at 15%, should consider accelerating dividend payments in 2012 to avoid having those same dividends taxed at the highest marginal tax rate of 39.6% and being potentially subject to the additional 3.8% Medicare surtax.

Where businesses set up as LLCs generate more than $250,000 to owners, the potential of having additional income subject to Social Security taxes may be reason to consider changing to a Subchapter S business entity.

Business asset expensing is also a critical category. There is a 50% bonus depreciation that is expiring, and the section 179 deduction that allows certain assets to be expensed instead of depreciated will be reduced from $139,000 in 2012 to $25,000 in 2013.

What's Next?

There are expiring provisions of the tax code that could lead to higher individual tax rates. Overall, the top rate may return to 39.6%. This is noteworthy for small business owners who operate pass-through entities, such as LLCs, where income is taxed at the owner's individual tax rate.

The coming year is scheduled to have some new taxes as well. Under the new health care law, a new 3.8% Medicare surtax will apply to net investment income for taxpayers with adjusted gross income exceeding $200,000 ($250,000 for married couples filing jointly). There will also be an increase in the employee Medicare tax of 0.9%.

2010-2012

Income Short-Term Capital Long-Term Capital
Tax Rate Gains Tax Rate Gains Tax Rate

10% 10% 0%

15% 15% 0%
25% 25% 15%
28% 28% 15%
33% 33% 15%
35% 35% 15%

2013 (Potential)

Income Short-Term Capital Long-Term Capital
Tax Rate Gains Tax Rate Gains Tax Rate

15% 15% 10%
28% 28%   20%
31% 31%   20%
36% 36%   20%
39.6% 39.6% 23.8%

Careful planning for business owners and individuals is needed before year's end, and the process should incorporate legal and accounting advice. A flexible plan with alternatives is the ideal approach where possible.

A Potpourri of Developments: Wandry Appeal Dismissed, Same-Sex Marriage Developments & 2013 Inflation Adjustments (Including $14,000 Annual Gift Tax Exclusion)

Thu, 25 Oct 2012 14:47:54 +0000

A Potpourri of Developments: Wandry Appeal Dismissed, Same-Sex Marriage Developments & 2013 Inflation Adjustments (Including $14,000 Annual Gift Tax Exclusion)

Sharon L. Klein

Managing Director & Head of Wealth Advisory

Lazard Wealth Management LLC

Here are some of the latest developments in the estate planning world.

Wandry Parties Agree to Dismiss Appeal to 10th Circuit with Prejudice

On March 26, 2012, the Tax Court issued what has been heralded as a ground breaking decision in Wandry v. Commissioner, T.C. Memo 2012-88. The Court upheld a stated dollar value defined value clause of gifts of LLC interests, in which no charity was involved in the formula allocation. A Notice of Appeal to the 10th Circuit was filed on August 28.

Pursuant to Stipulations to Dismiss dated October 16, the parties stipulated that the case be dismissed with prejudice, that each party bear its own appellate costs, and that an order of dismissal be entered by the Clerk of the Court. The Order dismissing the appeal was filed on October 17.

Same-Sex Marriage Developments

On the heels of last Thursday's decision by the Second Circuit in Windsor v United States, No. 12-2335 (2nd Circuit Oct. 18, 2012) that Section 3 of the Defense of Marriage Act is unconstitutional, I thought you would be interested in these developments on the same-sex marriage/union front.

Rhode Island Allows Marital Deduction for Same-Sex Spouses and Civil Union Partners

On September 21, 2012, the Rhode Island Division of Taxation issued a declaratory ruling regarding the Rhode Island estate tax marital deduction. Pursuant to the ruling, a Rhode Island estate tax marital deduction is allowable for property passing between partners of a Rhode Island civil union as well as same-sex couples lawfully married out of state, provided the requirements of IRC § 2056 are met. Rhode Island civil union partners and same sex-spouses lawfully married out of state are also allowed to include in the gross estate of a decedent one-half the value of certain joint property interests, provided the interest meets the requirements of IRC § 2040(b)(2).

New Jersey Introduces Bill Allowing Executor to File Joint Tax Returns With Surviving Same-Sex Partner

New Jersey law currently authorizes a fiduciary to join with a surviving spouse, executor or administrator to (1) file a joint income tax return for any period prior to the decedent's death for which no return was filed or (2) file a gift tax return for gifts made by the surviving spouse, consent to gift-splitting for any period prior to the decedent's death and pay taxes chargeable to the decedent. On October 11, identical bills were introduced in the Assembly and Senate to authorize a fiduciary to join with a partner in a civil union or a domestic partner (as well as a surviving spouse) to file such joint returns.

But in that Regard, a Reminder....From the IRS

In "Answers to Frequently Asked Questions for Same-Sex Couples," the IRS has posted questions and answers to provide information to same-sex partners whose marriage/union is recognized by state law. The IRS reminds same-sex partners legally married for state law purposes that they cannot file using married status because federal law does not treat same-sex partners as married for federal purposes.

Additionally, according to the FAQs:

- A taxpayer may not file as head-of-household if the taxpayer's only dependent is a same-sex partner;

- Either same-sex parent, but not both, may claim a child as dependent;

- A same-sex partner may itemize or claim the standard deduction regardless of whether the other partner claims the standard deduction or itemizes; and

- Each partner may claim the adoption credit for expenses paid or incurred by the partner during the adoption process, but both spouses cannot claim the credit for the same expenses.

The FAQs can be accessed at: http://www.irs.gov/uac/Answers-to-Frequently-Asked-Questions-for-Same-Sex-Couples

The IRS released a second set of FAQs, addressing same-sex filing issues in community property states. According to the FAQs, registered domestic partners and same-sex spouses who reside in community property states must each report half of the combined community income earned by the partners; all non-community income must be reported separately.

Registered domestic partners in California, Nevada and Washington who reported income on their pre-2010 returns without regard to community property laws, may, but are not required to, amend their returns to report half the community income of the partners.

The FAQs also address the reporting requirements of domestic partners for social security benefits, schedule C income, wages and other income, and clarify which partner is entitled to credits for income tax withholding, estimated tax payments, and various other credits and deductions.

These FAQs can be accessed at: http://www.irs.gov/uac/Questions-and-Answers-for-Registered-Domestic-Partners-and-Same-Sex-Spouses-in-Community-Property-States

2013 Inflation/Cost of Living Adjustments

On October 18, the IRS announced (1) 2013 annual inflation adjustments for more than two dozen tax provisions and (2) 2013 cost of living adjustments affecting dollar limitations for pension plans and other retirement-related items.

Among the highlights of the inflation adjustments:

• Annual exclusion: The annual exclusion for gifts rises to $14,000 for 2013, up from $13,000 for 2012.

• Gifts to Non-US Citizen Spouses: The annual exemption for gifts made to a non-US citizen spouse rises to $143,000 in 2013, up from $139,000 in 2012.

• Notice of large gifts from foreign persons: IRC section 6039F authorizes the IRS to require recipients of gifts from certain foreign persons to report these gifts if the aggregate value of gifts received in the tax year exceeds $15,102 in 2013, up from $14,723 in 2012.

• Kiddie tax: The amount used to reduce the net unearned income reported on a child's tax return subject to the "kiddie tax," is $1,000 in 2013, up from $950 for 2012.

Among the highlights of the cost of living adjustments:

• 401(k) Plan Contribution Limits: The contribution limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government's Thrift Savings Plan is increased from $17,000 to $17,500.

• Traditional IRA Contribution Phase-Outs: The deduction for taxpayers making contributions to a traditional IRA who are covered by a workplace retirement plan is phased out for singles and heads of household who have modified adjusted gross income (AGI) between $59,000 and $69,000, up from between $58,000 and $68,000 in 2012. For married couples filing jointly in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, the income phase-out range is $95,000 to $115,000, up from $92,000 to $112,000 in 2012.

• Roth IRA Contribution Phase-Outs: The AGI phase-out range for taxpayers making contributions to a Roth IRA is $178,000 to $188,000 for married couples filing jointly, up from $173,000 to $183,000 in 2012. For singles and heads of household, the income phase-out range is $112,000 to $127,000, up from $110,000 to $125,000 in 2012.

Some pension plan limitations will remain unchanged for 2013 because the increase in the index did not meet the statutory thresholds that trigger their adjustment.

Details about the inflation adjusted items for 2013 are included in Revenue Procedure 2012-41 and details about the pension related cost of living adjustments for 2013 are included in IR-2012-77, which can be found at the following links:

Revenue Procedure 2012-41: http://www.irs.gov/pub/irs-drop/RP-12-41.pdf

IR-2012-77: http://www.irs.gov/uac/2013-Pension-Plan-Limitations

ABOUT LAZARD WEALTH MANAGEMENT

Lazard Wealth Management is part of Lazard, one of the world's preeminent financial advisory and asset management firms. With origins dating back to 1848, Lazard operates from 42 cities across 27 countries in North America, Europe, Aia, Australia, Central and South America. Lazard Wealth Management takes an innovative and preservation-based approach to wealth management in servicing wealthy individuals, families and foundations. We provide a highly tailored suite of advisory and investment services, integrated across disciplines to deliver a breadth of solutions to clients' complex financial and strategic challenges.

For more information on Lazard Wealth Management, please visit http://www.lazardwm.com.

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, please be advised that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

This material is written by Lazard Wealth Management LLC for general informational purposes only and does not represent our legal advice as to any particular set of facts and does not convey legal, accounting, tax or other professional advice of any kind; nor does it represent any undertaking to keep recipients advised of all relevant legal and regulatory developments. The application and impact of relevant laws will vary from jurisdiction to jurisdiction and should be based on information from professional advisors. Information and opinions presented have been obtained or derived from sources believed by Lazard Wealth Management LLC to be reliable. Lazard Wealth Management LLC makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the date of this presentation and are subject to change.

Cashing in on 2012 Transfer Tax Exemptions Using Spousal Lifetime Access Trusts

Tue, 23 Oct 2012 17:03:14 +0000

Cashing in on 2012 Transfer Tax Exemptions Using Spousal Lifetime Access Trusts

By: Parker F. Taylor and Jason A. Lederman

Greenberg Traurig LLP

Unless the law is changed, at the end of 2012, the favorable estate and generation-skipping transfer (GST) tax rates and the amounts sheltered from those taxes under the Tax Relief Act of 2010 will end and less favorable ones will be reinstated. In 2012, the maximum Federal estate, gift and GST tax rates are capped at 35 percent. The maximum shelters from estate, gift and GST tax are unified at $5,120,000. On January 1, 2013, the maximum estate, gift and GST rates will revert to 55 percent. The maximum estate and gift tax shelter will revert to $1,000,000, and the GST exemption will revert to $1,000,000 indexed for inflation. This means that prior to 2012 year end, a couple can transfer up to $10,240,000 (assuming no prior taxable gifts were made) without incurring any gift tax. If the same transfer is made on or after January 1, 2013, the same couple would be limited to transferring $2,000,000 tax free (assuming no prior taxable gifts were made), and would incur substantial tax liability on the balance. In view of the potential increases in rates and reduction in shelters, clients should consider strategies to use their shelters during the remaining days of 2012 before up to $8,240,000 of transfer tax shelter potentially is lost forever.

Of course, the simplest strategy to maximize the use of the increased shelters would consist of making outright gifts to donees, free of trust, in 2012. While such gifts are possible, they often are not the most efficient use of shelters and may unnecessarily expose the gift to the donee's creditors or spousal attack in the event of the donee's divorce. Additionally, funds transferred in such a gift arrangement ultimately would be subject to estate tax as part of the donee's estate.

Another such strategy would be to create one or more trusts for descendants or other intended beneficiaries. If no prior gifts have been made, a couple could fund such a trust prior to year end 2012 with $10,240,000 without incurring any gift tax. If GST exemption is applied to the trust, no estate, gift, or GST tax would ever be incurred so long as the property remains in trust. This trust would be a so-called dynasty trust which would permit property to pass from one generation to the next with sufficient flexibility to permit the beneficiaries access to the funds while at the same time preserving the tax benefits for future generations.

For many donors, however, parting with up to $10,240,000 of assets is daunting at best. Clients often fear that such funds may be needed in the future for their care and general well-being. The Spousal Lifetime Access Trust ("SLAT") may provide such clients with a favorable gifting solution. A SLAT is an irrevocable trust created during a client's lifetime for the benefit of the client's spouse and descendants. The terms of a SLAT generally allow the trustee to make discretionary distributions to the donor's spouse and descendants.

In order to maximize the available transfer tax exemptions, ideally each spouse would

create a SLAT funded with up to $5,120,000 for the benefit of the other spouse and descendants. In order to achieve the intended transfer tax planning, the trusts must have different terms and must give the spouses different economic interests. Each spouse may have access to the trust for his or her benefit, provided that the beneficiary spouse is not granted an enforceable right to receive distributions from the trust, and that the access is not identical or reciprocal to the other spouse's trust. Also, it is best not to fund the trusts with the same assets and not to create the trusts at the same time. Given these "best practices", planning should be undertaken as soon as possible.

Failure to differentiate the SLATs sufficiently could result in the IRS attempting to unwind the transfers. In essence, the IRS could assert that because the SLATs were created at approximately the same time, using similar or identical assets and naming similar beneficiaries, the transfers should be disregarded for tax purposes and uncrossed (i.e., the trust for the beneficiary spouse is included in the beneficiary spouse's estate upon the beneficiary spouse's death) FN1. In such a case, the IRS could contend that the donor spouse has been left in "approximately the same economic position as if he or she had simply named himself or herself life beneficiaries of his or her own trust," and, as a result, seek to unwind the transfer FN2. This is commonly referred to as the "Reciprocal Trust Doctrine".

The most conservative approach to planning with SLATs would be to have one spouse create a SLAT for the benefit of his or her spouse and descendants and the other spouse create a dynasty trust for the benefit of his or her descendants only. This should preclude any assertion of the Reciprocal Trust Doctrine.

More often than not, however, each spouse would prefer to have access to the other spouse's trust. This may be accomplished without running afoul of the Reciprocal Trust Doctrine by varying the terms of the trusts. In Levy v. Commissioner, T.C. Memo 1983-453 (1983), the Tax Court held that including a special power of appointment in one spouse's trust but not the other spouse's trust was a sufficient variation in the terms of the SLATs so as not to render them reciprocal. Donor spouses should consider varying other trust terms as well, such as trustee appointments and distribution standards. Additionally, SLATs could be formed in a self-settled trust jurisdiction (such as Alaska). By doing such, if the SLATs are unwound, an argument may be made that the gifts to the SLATs are still complete because the SLATs' assets are insulated from the creditor claims of the beneficiary spouse who, under the Reciprocal Trust Doctrine, would be considered the donor spouse of the SLAT created for his or her benefit.

As a final measure, donor spouses should consider including provisions in the SLATs for backup marital deduction trusts. As a result, any estate taxes imposed would be deferred until the second spouse's death. The SLATs would include terms that provide if upon the first spouse's death the assets of either of the SLATs are includible in the estate of the first spouse, such assets would be held in a marital deduction trust for the benefit of the surviving spouse. This would prevent the IRS from receiving an immediate financial windfall in the form of estate taxes by unwinding the SLATs.

Properly drafted SLATs are also advantageous because they can terminate upon the happening of an act of independent significance, such as divorce, bankruptcy, insolvency or death of the beneficiary spouse. This can provide the donor spouse with some comfort in such an event. In addition, SLATs can be drafted as intentionally defective grantor trusts to shift the income tax burden to the donor spouse as opposed to the SLAT bearing its own income tax liability. The donor spouse's payments of income taxes on behalf of the SLAT would not constitute additional gifts. This can have the effect of further leveraging gains inside the SLAT by allowing the trust assets to grow income tax free FN3, FN4.

As the 2012 year end fast approaches, individuals with substantial resources should consider transferring wealth to maximize the inflated transfer tax credits which will soon expire. Carefully drafted SLATs offer a great mechanism to capitalize on the current large transfer tax shelters while permitting each spouse to have access to the other spouse's trust for his or her benefit.

Parker F. Taylor and Jason A. Lederman are attorneys at Greenberg Traurig who practice in the areas of trusts and estates, and taxation.

________________________________

1 See G. Slade, "The Evolution of the Reciprocal Trust Doctrine Since Grace and Its Current Application in Estate Planning," 17 Tax Mgmt Est. Gifts & Tr. Jl. (1992).

2 See US v. Estate of Grace, 89 S.Ct. 1730 (1969).

3 Rev. Rul. 2004-64, 2004-2 C.B. 7.

4 See Gans, Blattmachr & Zeydel, Supercharged Credit Shelter Trust, 21 Probate and Property 4, July-August 2007

IRS Posts Final Form 706 and Instructions for 2012 Decedents

Thu, 11 Oct 2012 12:50:15 +0000

IRS Posts Final Form 706 and Instructions for 2012 Decedents

Sharon L. Klein

Managing Director & Head of Wealth Advisory

Lazard Wealth Management LLC

On October 4, the IRS posted final Form 706 for individuals dying in 2012. Final instructions were posted on October 5.

Taken together, highlights of the changes from the draft forms I previously described include the following:

Portability Opt Out Highlighted, DSUE Chart Tweaked

As in the draft form, the new Part 6 - Portability of Deceased Spousal Unused Exclusion (DSUE) states that a decedent with a surviving spouse elects portability of the DSUE amount, if any, by completing and timely-filing Form 706. No further action is required.

There is a box to check to opt out of portability that has been highlighted compared to the draft form by including it in its own separate section "Section A. Opting Out of Portability." Presumably, the intent was to further minimize the risk of mistakenly checking the box and inadvertently opting out of portability.

The DSUE amount received from predeceased spouse(s) calculated in Part 6, Section D includes a column for listing the DSUE amount applied by the decedent to lifetime gifts. Instead of the date of the gift as requested in the draft form, the final form requests the year of Form 709 reporting the use of that DSUE amount.

Special Valuation Rule for Estates Filing Solely to Elect Portability

Estates that do not otherwise have a filing requirement (ie, Form 706 is filed solely to elect portability) do not have to report the value of certain property that qualifies for the marital or charitable deduction. A more detailed note has been added to the top of Schedules A, B, C, D, E, F, G, H, I, M and O to direct those under the filing threshold who are filing solely to elect portability to consider whether it is necessary to report the value of certain assets eligible for the marital or charitable deduction. If the value of an asset is not required to be reported pursuant to the special valuation rule, the executor must:

1. Report the asset on the appropriate schedule, but without any value on the schedule itself; and

2. Estimate in good faith and with due diligence the total value of the gross estate, using ranges of dollar values now provided in Form 706 instructions. As you may recall, the draft instructions provided guidance for estimating the value of assets only up to $1,000,000. The final instructions provide guidance for assets valued up to $5,120,000, in $250,000 increments (with the last increment being $5,000,000 - $5,119,999).

Line 7 Worksheet - Used to Determine Applicable Credit Allowable for Prior Periods

The Line 7 Worksheet (used to determine the applicable credit [formerly unified credit] allowable for prior periods) has been amended in final Form 706. A column has been added for specifically listing the DSUE amount from a predeceased spouse actually applied to prior gifts, which amount is to be taken from the gift tax return for the applicable year. Additional columns clarify that the DSUE amount applied against lifetime gifts is added to the applicable exclusion amount for the current period and multiplied by the 2012 unified rate schedule to compute the maximum applicable credit. The "total gift tax paid or payable" is determined on the Line 7 Worksheet and entered on Part 2 - Tax Computation, Line 7.

And Remember to Write Neatly...You'll Need to Submit Your Worksheet

Filers were previously directed not to file the Line 7 Worksheets, but to keep them for their records. Now a specific cautionary note appears in the instructions directing the filer to submit a copy of the Line 7 Worksheet when filing Form 706.

Links to the final Form 706 and its instructions for 2012 decedents are included below, for your information:

http://www.irs.gov/pub/irs-pdf/f706.pdf

http://www.irs.gov/pub/irs-pdf/i706.pdf

ABOUT LAZARD WEALTH MANAGEMENT

For more information on Lazard Wealth Management, please visit http://www.lazardwm.com.

IRS Posts Draft 2012 Gift Tax Return Instructions

Fri, 05 Oct 2012 13:20:11 +0000

IRS Posts Draft 2012 Gift Tax Return Instructions

Sharon L. Klein

Managing Director & Head of Wealth Advisory

Lazard Wealth Management LLC

The IRS posted draft instructions for draft 2012 Form 709 on September 28, 2012. Highlights of the instructions include the following:

Check the Box to Indicate Use of Deceased Spousal Unused Exclusion (DSUE)

As noted in a prior email, there is a new check-the-box question in Part 1 (Line 19), which asks:

"Have you applied a DSUE amount received from a predeceased spouse to a gift or gifts reported on this or a previous Form 709?"

The instructions remind the reader that, in order to be eligible to use a predeceased spouse's DSUE, the spouse's executor must have made an election to use the unused exclusion amount on Form 706. If the election was made, a copy of Form 706 must be attached to Form 709, as well as a calculation of the DSUE amount (either as an attachment or as reflected on Form 706, Part 6).

Schedule C - Portability of DSUE Amount

The instructions provide more detailed guidance regarding completion of Schedule C - Portability of DSUE Amount. As noted in a prior email, several lines marked "reserved" have been added to the latest draft Form 709. The instructions provide that the reserved lines are "inactive" and that no information is to be entered on those lines.

In Parts 1 & 2 of Schedule C, the DSUE received from a last deceased spouse and the DSUE received from other predeceased spouse(s) are reported (predeceased spouses must have died on or after January 1, 2011).

The donor's applicable credit amount is calculated by (1) adding (a) the basic exclusion amount and (b) the total DSUE amount from the last and previously predeceased spouses applied by the donor to lifetime gifts (including current and prior gifts), and (2) applying to that sum the appropriate tax rate from the rate table in the instructions. The result is to be entered on Line 7 of Part 2-Tax Computation.

And a Note of Caution...

The instructions caution the reader that any remaining DSUE from a predeceased spouse cannot be applied against tax arising from current gifts if that spouse is not the most recently deceased spouse on the date of the gift. The instructions note that rule applies even if the last predeceased spouse had no DSUE amount, if the portability election was ineffective or not made at all, or if the DSUE amount from the last deceased spouse has been fully applied to gifts in previous periods.

For your information, you can find the draft Form 709 instructions at the following link: http://www.irs.gov/pub/irs-dft/i709--dft.pdf

ABOUT LAZARD WEALTH MANAGEMENT

For more information on Lazard Wealth Management, please visit http://www.lazardwm.com.