High net worth clients require a different nature of planning than other clients. Practitioners serving these clients need to address a range of sophisticated estate tax minimization steps that are simultaneously designed to minimize income tax impact to these clients. While high net worth does not necessarily imply high income, it often does, so for purposes of this article it will be presumed that it does. While most of the planning points are targeted at the ultra-high net worth client, many are applicable to the merely wealthy client as well.
√ Review FLP/LLC Agreements
High net worth clients commonly have entities that own investment and business interests. In the event of a death, the ability to step-up the inside basis of the membership interest in an entity is important to preserve. If the governing legal document for the entity does not mandate that the entity will make the election to step-up basis under IRC Sec. 754 your client may not obtain this benefit. The optimal time to negotiate for such a provision to be included in the partnership or operating agreement is before it is necessary. One of the most important and universally overlooked steps is for the client, CPA and attorney (and in some instances other advisers) to periodically review the partnership or operating agreement for an FLP/LLC or the shareholder’s agreement for a family S corporation to see what operational mandates it provides for. CPA practitioners will often maintain accounting records for a client entity, prepare tax filings and provide general planning advice while never reviewing the actual governing legal document. What might be sound tax planning, compliance or business advice might prove contradictory to the terms of a form shareholders’ agreement the family signed a decade ago and no one has looked at since. Why might anyone care? If there is a lawsuit or claim and an effort is made to pierce the entity to reach personal assets of the client, ongoing operation of the entity in direct contradiction of the terms of the governing instrument could be a potent line of attack. If a family member/equity holder divorces it is assured that counsel for the ex-spouse will review the governing agreement with the proverbial “fine-tooth comb” looking for hooks for lines of attack. The only sensible approach, which in most instances will never occur absent the CPA practitioner insisting on it, is to have a meeting to review the operational aspects of the document. What must the client, the CPA, and others do each year to comply with the terms of the governing agreement (or in turn if the governing agreement provisions are no longer reasonable, what steps should be taken to update it). What are some of the many actions that might be governed by a partnership agreement:
• Compensation for equity owners and their family. You may have taken great precaution to corroborate the arm’s-length nature of a salary for a child but if the agreement prohibits or caps compensation there is a problem irrespective of your diligent efforts.
• Related party transactions and payments for them. Some boilerplate prohibits related party payments, some require a super-majority (e.g. 2/3rds approval by partners) for a related party payment. The boilerplate in other agreements merely requires it be arm’s length. You cannot advise a client as to how to operate, plan for income taxes, or support related party transactions, without first understanding what the governing instrument provides for.
• Distributions are typically made whenever the primary client decides they are made. But if the agreement mandates first assuring an “adequate working capital” (or any other prerequisite) then no distribution should be made until the CPA practitioner has helped the client corroborate that those prerequisites have been complied with.
Example: The client has substantial operating business interests and real estate held in a family LLC. 40% of the LLC interests were sold to a dynasty trust in a note sale transaction. 35% of the LLC interest was gifted to a tier of grantor retained annuity trusts (GRATs). The attorney for the family carefully delineated that the client as manager of the family LLC must carry out all functions with due regard to her fiduciary obligations to the LLC and to the members of the LLC. That provision should help deflect an IRS attack that the LLC should be pulled back into the client’s estate under IRC Sec. 2036 by virtue of her being the manager and controlling distributions. The client dies and the IRS audits the estate. The examining agent reviews the operating agreement on the estate tax audit and the pattern of distributions, and identifies that all distributions were made in contradiction of the express terms of the operating agreement. This evidence is presented to demonstrate that the decedent had held unfettered control over distributions by the LLC, that there was an implied agreement between the trustees of the various trusts that controlled 75% of the LLC membership interests and the decedent that she retain unfettered control. The IRS asserts that the entirety of the LLC interests are included in the client’s estate undermining the entire estate plan and resulting in tens of millions of additional estate tax.
√ Operational Formalities
Wealthy clients frequently use entities and irrevocable trusts in their planning. However, those entities and trusts must observe the requirements mandated by their legal format.
Example: The President or another officer of an S corporation should sign entity legal documents and tax returns using their correct title. Has the client signing entity tax returns properly been designated as having that position? When is the last time that officers and directors were appointed? In addition to these requirements, provisions included in the entities governing documents (e.g., an operating agreement for an LLC) must also be adhered to. For example, if a partnership agreement requires that certain reserves be maintained, are they? If a 2/3rds vote of members is required for a capital improvement, have those votes occurred and been documented? If a trust includes specific investment mandates for trust assets, have they been followed and documented in a trust investment policy statement? Failure to adhere to legal or governing instrument requirements can torpedo the tax, control and asset protection benefits of these entities and trusts. Too often accounting practitioners presume these matters are all issues for the client’s lawyer to address. That is a dangerous misconception. If you are providing compliance services you want to be certain that the appropriate person is signing the returns. If you provide investment or financial planning advice, you don’t want to find that your recommendations were in direct contradiction of the provisions of the governing instrument. Most significant, many clients are unwilling to monitor these issues on a regular basis with their attorneys unless another professional adviser pushes them to do so. CPAs must remain proactively involved in monitoring all of the complex planning structures for wealthy clients.
Consider the following:
• Create a permanent file for each client trust and entity.
• Each engagement letter and tax return must be signed by the appropriately authorized person. The primary client may be the grantor (settlor) of a trust but have no authority to sign either a tax return or engagement letter.
• Complex trusts for wealthy clients often include an array of fiduciaries and other persons. A trust might have: an institutional general trustee, an investment adviser, trust protector, person authorized to make loans, the grantor may hold swap powers, heirs may hold Crummey powers, etc. In all matters in which practitioners are involved, and all documents obtained for a trust, LLC or other client permanent file, be certain the correct person signed in the correct capacity.
• Consider filing tax returns for all grantor trusts to at a minimum corroborate the existence of the trust.
• Be certain that income taxes, annual report fees and other often nominal expenses are paid from the correct accounts. If a client personally pays a tax return preparation fee for an inexpensive grantor trust return for an irrevocable trust that payment constitutes an indirect gift to the trust for which a gift tax return has to be filed. That modest payment could have GST tax planning implications. Most significant that payment might be raised as an example by a creditor or the IRS (or both!) that the client disregarded the independence of the trust. A few minor infractions like that (the grantor paid a trustee fee for the trust, the wrong fiduciary signed a tax return, and so on) could be proffered as a pattern of disregard in a later divorce case.
• Plan distributions in advance from any trust. Should the payment be a distribution to a beneficiary? Should it instead be a loan (and if so have it properly documented and assure an appropriate interest rate is charged), should it be a tax reimbursement (does the trust instrument permit this?) or some other transaction? What life events are occurring for the client? Is it advisable to take the distribution (or other payment) at a different time so as not to create an impression that the client has unfettered access to the trust to pay for life events. This is the type of argument the IRS (or perhaps counsel for a divorcing spouse) may advance to support that there was an implied agreement between the client and the trustee. Clients too frequently simply write checks or ask for distributions with nary a regard for the implications of that. The client may well be entitled to access funds in an irrevocable trust, but the manner in which he or she does so is critically important to the success of the entire plan.
√ Asset Protection
Too often planning has focused on tax minimization not overall planning. Wealthy clients obviously have more to lose to a lawsuit, divorce or claim than other clients. In 2015 wealthy clients will be able to transfer $5,430,000 free of estate tax. A married couple will be able to transfer $10,860,000. In prior years a client with $10 million+ of net worth would have been rather likely to pursue estate tax minimization. The use of FLPs, LLCs and irrevocable trusts that typically are used in such planning would have also provided meaningful asset protection benefits. Now, however, a client at this wealth level may not be motivated to pursue any significant estate tax planning since they are under the federal exemption (assuming portability is used). Practitioners need to be alert to guide these clients to pursue asset protection planning regardless of the client’s concern about estate tax planning (but see comments below). Asset protection planning should include a foundation of appropriate property, casualty and liability coverage. Wealthy clients should all have excess liability coverage that provides higher dollar coverage above the liability coverage included in homeowners and automobile policies. Significant non-qualified marketable securities could be held in tiers of LLCs/FLPs and those interests in turn held in irrevocable trusts to provide protection from claims.
√ Spousal Lifetime Access Trusts
One of the very popular estate and asset protection planning techniques for wealthy clients is for each spouse to create a trust for the benefit of the other spouse and for the couple’s descendants. This can indirectly provide each spouse with access to the funds in the other spouse’s trust.
Example: Husband creates a trust for the benefit of Wife, children and all descendants and his mother (so that there is a different beneficiary in his trust as she will not be included as a beneficiary in Wife’s trust). Wife creates a similar trust for the benefit of Husband, children and all descendants. Husband may receive distributions from Wife’s trust and Wife may receive distribution from Husband’s trust so that the couple as a whole still has access to funds that are arguably outside of both estates and unreachable by either spouse’s creditors. These trusts can be quite robust and serve a range of planning purposes. Each trust might appoint a special trustee to handle life insurance decisions and include a range of life insurance powers. Because the trusts hold other assets (and therefore serve as asset protection trusts) this obviates the need for annual gifts and the burdens of annual Crummey powers. Earnings from the assets in the trust can be used to pay for life insurance premiums. Because all descendants are included as beneficiaries these trusts serve the planning objective of dynastic trusts. These trusts should be structured as grantor trusts so that note sale (see below) and other transactions are feasible. If sufficient wealth is transferred to these trusts the grantor trust burn, growth in assets outside of the estate on gifted (and sold) assets, life insurance proceeds, in aggregate can eliminate over time any federal estate tax burden on a substantial estate while permitting the clients meaningful access to trust assets. To achieve all of these goals in optimal fashion these trusts should be created in a state that permits self-settled trusts and has other trust “friendly” legislation including a very long rule against perpetuities period (how long a trust can last), favorable trust income tax system, courts experienced and favorable to sophisticated trust planning, etc. The four most common jurisdictions used for this type of planning are Alaska, Delaware, Nevada and South Dakota.
√ Estate Tax Deferral
Given the importance of basis step-up to planning it may be more advantageous for some clients, especially those holding negative basis real estate (see below) to retain certain assets in the taxable estate. This can be the exact opposite of estate planning goals only a few years ago which almost uniformly sought to remove appreciating assets from the client’s estate in order to reduce estate tax. Affirmatively planning to retain business, real estate and perhaps other assets in a client’s estate (and perhaps the corollary reliance on a more robust permanent life insurance plan to address estate tax costs) will increase the reliance on the use of the estate tax deferral provisions under IRC Sec. 6166. Practitioners should proactively endeavor to help clients plan so that their estates can qualify for the benefits of IRC Sec. 6166 estate tax deferral so that the benefits are not inadvertently lost. The following are some of the requirements:
• The executor must elect to defer the payment of estate taxes. As part of the election, the executor must file an agreement with the IRS as described in IRC Sec. 6324A(c).
• In order to qualify for the deferral of estate tax the decedent must have been a U.S. citizen or a resident alien. IRC Sec. 6166(a)(1).
• Only interests in a closely held business may qualify for the deferral of estate tax attributable to their value. An "interest in a closely held business" is defined as:
• A sole proprietorship that operated a trade or business.
• A partner in a partnership carrying a trade or business, if 20% or more of the partnership value is included in the decedent’s gross estate. There must also be less than 45 partners in the partnership.
• Stock in a corporation carrying on a trade or business if 20% or more of the voting stock of the corporation is included in the decedent’s gross estate. There must be less than 45 shareholders regardless of class of stock owned. IRC Sec. 6166(b)(1).
• The interests in closely held or family businesses that qualify must in the aggregate exceed 35% of the decedent’s adjusted gross estate. The value of the active business assets are considered for the 35% rule. Any closely held real estate investments, or business assets, which are passive in nature are excluded from the qualifying value for purposes of the application of the 35% test.
Practitioners helping clients monitor the percentage tests above when qualifying for IRC Sec. 6166 estate tax deferral will be advantageous. Also, steps should be taken to corroborate the active nature of business interests intended to qualify. Finally, estate planning and other transfers that might cause the number of equity holders to exceed the maximum permitted above should be reviewed.
√ Monitoring Grantor Trust Status
Most sophisticated trusts designed for high net worth clients are structured as grantor trusts. A major incentive for this approach is to permit the settlor/client to continue to pay income taxes on the earnings inside the trust. This results in a continued reduction in the size of the clients estate, due to the so called “tax burn,” while the growth inside the trust which is outside the client’s estate, is enhanced by the benefit of what is effectively for the trust an income tax free environment. Over the years the impact of this tax burn can become “too much of a good thing.” For some clients a crossover point will be reached when the benefit of the tax burn is no longer necessary. This is a particularly sensitive and important issue if a sale of a highly appreciated trust assets (e.g. a family business being purchased by a large public company) is being contemplated.
• Practitioners should review the status of each grantor trust each year with their clients and discuss the future prospects for the trust assets.
• Balance sheets for the client and the trusts should be prepared and reviewed.
• Monitor the inflation adjusted remaining estate tax exemption for the client. For wealthy (but not ultra-high net worth clients) the aggregate impact of: (1) annual inflation adjustments to the exemption; (2) the tax burn from grantor trusts; and (3) the normal course of spending an estate down post-retirement, may obviate the need for the continuation of grantor trust status.
• Compare the above analysis and projections of the future impact of continued grantor trust status to the real need for any new proposed estate planning. The client’s estate planning attorney might recommend further estate planning transfers to reduce the estate when the combination of the factors noted above, and the availability of an already existing life insurance plan, may more than adequately address any tax costs. This is not only a matter of not having a client pursue unnecessary planning, it is also a matter of assuring that appreciating assets that can remain in the estate to receive a step-up in basis in fact do so.
• Bear in mind that the step-up in basis benefits and the annual inflation adjustments to the estate tax exemption are relatively new to the planning picture and have a different impact on planning recommendations than what most planners have traditionally pursued.
If grantor trust status is no longer needed, or a sale of a large appreciated asset might make the impact of grantor trust status too painful to the client, consider turning off grantor trust status. The following might be relevant to that process:
• Review with the client the possibility that if grantor trust status is turned off it may never be turned back on again. Even if the trust instrument permits a light-switch approach (on-off-on) some commentators advise that this should not be done.
• Does the trust have a tax reimbursement clause that might provide a means of tempering the impact of grantor trust status while retaining its benefits in the event it cannot be turned back on? Is the trust formed in a state where this clause will not cause estate inclusion and make trust assets reachable by creditors?
• Consider whether the trusts have the wherewithal to make loans to fund the grantor’s cash flow needs. This might provide a means to address financial concerns while retaining grantor trust status that for the future years might still be advisable.
• What do the terms of the trust instrument provide for? What steps need to be taken, by whom and how, to turn off grantor trust status? What notifications might be appropriate to include on the tax returns affected?
√ Insurance Trust Traps on Grantor Trust Status
There are several issues that must be evaluated at the planning stage, and if not, at the appropriate future date (e.g. when a discussion occurs about turning off grantor trust status) concerning life insurance trusts. If trust income can be used, directly or indirectly, to benefit the grantor, the grantor will be treated as the owner of the trust. IRC Sec. 677. This includes the application of income to pay premiums on life insurance policies insuring the life of the grantor or the grantor’s spouse. IRC Sec. 677(a); Treas. Reg. Sec. 1.677(a)-1. Specifically, the grantor is deemed the owner of any portion of the trust or the trust income which can be used (without the consent of an adverse party) to pay premiums on life insurance policies. IRC Sec. 677(a)(3). Prior cases, under a predecessor statute, held that the grantor was only taxable on trust income actually used to pay premiums. Rand v. Comr., 40 B.T.A. 233 (1939), acq., 1939-2 C.B. 30, aff’d, 116 F.2nd 929 (8th Cir. 1941), cert. denied, 313 U.S. 594 (1941). The IRS has held that if trust income is used to purchase life insurance even in contradiction of the terms of the trust, the trust will still be characterized as a grantor trust. PLR 8839008. The application of trust income to discharge the grantor’s legal obligation of supporting his or her spouse will also taint the trust as a grantor trust. IRC Sec. 677(b); Treas. Reg. Sec. 1.677(b)-1. If trust income can be used to pay the grantor’s mortgage, the trust will be taxed to the grantor. Rev. Rul. 54-516, 1954-2 C.B. 54. Many practitioners believe that if a trust holds life insurance it is automatically characterized as a fully grantor trust. The ability of a trustee to use trust income to pay insurance premiums on the life of the grantor might be advanced as the basis for this. Other practitioners are concerned that this may characterize the trust as a grantor trust as to income but not assuredly as to principal. Thus, if a trust is desired to be wholly grantor it may be advisable to include an additional power such as a swap power, the right to loan without adequate security, etc. in the trust instrument. If an existing trust does not have those additional powers it may be advisable to consider decanting into a new trust which includes additional grantor trust powers (although the tax issues that modification might raise should be considered). There is potentially another planning implication to life insurance trusts. If the grantor desires to turn off grantor trust status it is not clear according to some trust instruments that the trustee can merely stop using trust income to pay for premiums and thereby achieve an end to grantor trust status. It might be preferable to have a trust protector or other person hold a power to trigger a prohibition against the trustee using trust income to pay for premiums.
√ Plan Now Before Estate Tax Laws Change
Is permanent really “permanent.” While the 40% rate and $5.43 million inflation adjusted exemption are permanent that term can mean whatever the next vote in Congress decides it means. Any wealth client should aggressively plan to minimize future estate tax costs before the laws are changed adversely. Certainly there remains a possibility that the estate tax might be repealed. But there have been and continue to be proposals to make the estate tax incredibly harsher. GRATs may be restricted, the use of grantor trusts and especially note sale transactions to grantor trusts (perhaps the favored wealth shifting tool for ultra-high net worth clients) prohibited ( by mandating estate inclusion of asset sold to a grantor trust), etc. Act now.
√ Grantor Retained Annuity Trusts (GRATs)
GRATs are a powerful tool for shifting wealth. For the ultra-high net worth client the estate tax exemptions that seem so incredibly high for the vast majority of merely wealthy Americans are quite inadequate. Note sales to grantor trusts and GRATs that can shift tremendous wealth beyond the level of the exemption amounts are ideal. For the very wealthy client, the (albeit fictitious) convention of requiring a 10% seed gift to support a sale to a grantor trust caps the wealth transfer using a note sale to about $100 million (depending on the practitioner you question, the interpretation of the law, the practitioner’s comfort with using guarantee arrangements, and of course the alignment of the stars on the closing date). For these clients GRATs are a great tool for shifting large additional wealth. The viability of GRATs is potentially in jeopardy because of the proposals to restrict thier use (10 year minimum GRAT term, no more zeroed out GRATs, etc.) and the potential that increases in interest rates in the future will make the technique less advantageous than in the current low interest rate environment. When planning and structuring GRATs consideration should be given to the term of the GRATs used. For many practitioners the two year rolling GRAT format is GRAT heaven. However, if you are concerned that at some point interest rates may rise, and perhaps substantially, it may be advantageous to instead have client’s tiers of GRATs to shift wealth. Longer term GRATs will lock in current low interest rates for the duration of the GRAT. To address mortality risk a longer term GRAT necessarily is subject to tiers of GRATs (i.e., GRATs expiring in different years, or laddered GRATs) and perhaps offsetting life insurance (e.g., a 10 year term policy to backstop the mortality risk of a client dying before a 10 year GRAT matures) might be used.
√ Monitor Defined Value Clause Mechanisms
Many complex gift and sale transactions have been backstopped by the use of various types of defined value mechanisms. These mechanisms might provide that the client has transferred a specified number of shares of stock in a corporation but that the number of shares of stock that were transferred by sale to a grantor trust is capped or defined as a specified dollar figure, say $50 million, and the balance, if any of the stock (i.e., the balance that will be created if the IRS successfully asserted that the value of the stock shares involved exceeded the $50 million appraised value) was transferred effective at the date of the sale to the client’s private foundation. Practitioners should monitor the reporting of these items for all purposes. Perhaps Forms K-1 for the S corporation whose stock was subject to the sale/defined value clause should report the percentage ownership of the particular K-1 with an “*” asterisk and an indication that the actual number of shares depends on the terms of the defined value clause contained in a stock purchase agreement dated [insert date]. Also, when the period for an IRS audit expires, or if there is an adjustment as a result of an IRS audit, the documentation and reporting must all be adjusted. If the existence of the defined value mechanism and its terms are not acknowledged and respected by the client the IRS may assert that in a challenge to the effectiveness of the mechanism. If a distribution is to be made to shareholders while the uncertainty of the defined value mechanism remains active (i.e., before the period for IRS audit has expired) how should that distribution be handled?
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