CCH - Leimberg Services



Closely Held Business Planning in 2012

By: Martin M. Shenkman, PFS, AEP, Esq., and Richard Greenberg, Esq. and Glenn Henkel, Esq.

Introduction

Now that the NFL replacement referee fiasco is over, we can focus attention on common issues facing closely held business owners as 2012 comes toward a conclusion. These issues include: succession planning, protecting assets from lawsuits and other claims and minimizing estate taxes (especially in light of the liquidity issues faced by most closely held businesses). The unique estate tax planning opportunities that exist in 2012, if properly coordinated and implemented in conjunction with business succession and asset protection goals, can help accomplish all of these objectives. Much has been written about the 2010 Tax act compromise that has created a new set of estate planning rules for the rest of 2012. However, comprehensive planning will have to address a range of issues and include steps that are quite different then the historical paradigm for transferring interests in closely held businesses. A typical wealth transfer plan for a family business many years ago relied on regular annual gifts of stock in the family business. While many family businesses are held in the form of Limited Liability Companies (“LLCs”), it is not unusual that the business is a corporation that has elected ‘flow through’ tax treatment as an S Corporation. Each form of business ownership has unique challenges to practitioners weighing the various important planning goals with tax planning objectives.

Historically, the most common family business planning strategy began with a transfer by gifts of interests in S corporation stock (before the advent of LLCs) using the gift tax annual exclusion. This gave way to a more common use of grantor retained annuity trusts (“GRATs”) to transfer business interests to the next generation. As “grantor trusts”[1] they qualify to hold S corporation stock and maintain the preferred tax status of the corporation. When the GRAT term ends, the stock may remain in trust and this “back end trust” if not a grantor trust could be structured as other trusts that are permitted to hold S corporation stock, a QSST or ESBT [2]. These techniques have evolved more recently into the use of long term or so called “dynasty trusts” and even techniques where the parent sells stock to the trust retaining a note (the note sale to a grantor trust).

Because of the 2012 gift tax opportunities, gift planning this year proceeds in a different manner than the previous historic planning paradigm. Many business owners still have not seized on the opportunities of the current exemption, discounts, etc. Perhaps many smaller businesses have been incorrectly dissuaded from proceeding under the premise that the current $5 million + estate tax exemption obviates the need for planning. Others may not realize that the estate tax exemption is only one important tax benefit that may be repealed. This article will explore:

• Planning techniques for all closely held businesses.

• Why smaller closely held businesses should act now.

• Why larger closely held businesses should act now.

Why Business Owners Aren’t Planning

While the incentives to plan today and plan aggressively are tremendous, most business owners still seem reluctant to pull the trigger. There are a number of tax hurdles that impede planning progress:

• Years of ongoing uncertainty over the fate of the Federal estate tax have frustrated many taxpayers who could be affected. While it is clearly more advantageous to plan under current tax law rules than the rules that could be effective in 2013, that “could be” is not certain. Most recently, there has been rumor of a six month extension of current law. But that is mere rumor and should not be relied upon to delay proactive planning.

• If assets are given away, they are not included in the gross estate of the business owner on death. This could result in the loss of the ‘step-up’ in tax basis to the fair market value that is afforded to most assets (not IRD) that are included in a decedent’s estate. Thus, improvident gifts could require heirs to forgo a basis increase that might otherwise have saved capital gains taxes that may be much higher in the future than the potential estate taxes that might be saved. While uncertainty exists on all sides, making a decision (or advising on a decision) is not simple.

• The costs involved in this type of planning, both up front and ongoing, are all material. Business owners hurt by the recession that seems to continue to drag on are especially sensitive to costly investments in professional fees that no one can assure will lead to any real savings.

• Complexity and paperwork abound. For even the most successful business owner, it is a challenge (headache!) to grasp the complex acronyms that comprise a modern estate plan: GRAT, IDIT, DAPT, ILIT, and so on. But once the planning is done, the complexity and paperwork cannot dissipate. If sophisticated gift trusts are not properly created, administered and reviewed on a regular basis by qualified professionals with the appropriate knowledge and experience, planning is likely to fail. No business owner appreciates the added complexity and administrative burdens.

There are also significant non-tax issues to consider for any estate plan for a family or other closely held business. Entrepreneurs tend to have developed their wealth through maintaining control. Any plan adopted will likely entail some irrevocable transfer, thus loss of some control. Business owners must weigh the potential losses to be incurred as a result of a future estate tax against the costs, complexity, uncertainty and possible greater capital gains tax rates. While the decision is not simple, as the size of the estate involved increases (and if the business owner lives in a “decoupled” state that imposes its own estate tax on amounts much lower than $5.12 million), the costs and complexity of any plan may seem to pale in comparison to the potential benefits. While potential higher capital gains rates in the future seem to militate against making current gifts, wealthy taxpayers often have a host of options available to defer or eliminate capital gains: donating appreciated business interests to charity or to a charitable remainder trust, harvesting gains and losses, like kind exchanges, and so forth.

Clients Who Have Utilized Their Exemptions and Smaller Estates -- It’s Not Only About the $5.12 Million Exemption

It seems that the professional literature and firm announcements today focus on utilizing clients’ $5.12 million estate tax exemption. While the ultrahigh net worth crowd is clearly the group that will benefit most from significant wealth transfers in 2012, the focus on such large assets transfers downplays two significant classes of clients who can also benefit from continued 2012 planning.

Some wealthy clients have already exhausted their gift/estate tax exemption amount. Some clients that have small remaining exemptions prefer to keep them intact as a “cushion” in the event of a gift tax audit or as gunpowder for a future planning endeavor (although a reduction in the exemption may eliminate what they believe is a remaining exemption). These clients may benefit from continued business wealth transfer planning using a range of techniques that do not require use of the gift tax exemption. For instance, clients might:

• Gift business interests to grantor retained annuity trusts (“GRATs”) that are nearly zeroed out (e.g., the value of the retained interest is approximately the same as the gift). This also is important if, in fact, the client’s entire exemption has been used. While some practitioners continue to push GRATs for 2012 planning because of the Treasury “Green Book” proposals that mandate minimum ten year terms, GRATs structured in the zeroed out manner will not utilize the $5.12 million exemption amount that may disappear by 2013. While it is possible to structure an exceptionally large transfer of business interests to a GRAT with the annuity payment structured to cause a present value gift near the $5.12 million exemption, the authors have not seen this approach applied. GRATs, however, are an ideal technique to consider if the client has already utilized a large portion of his or her exemption amount and have additional business interests to transfer. In that context, the use of a GRAT would have to be compared to the alternative of some type of note/sale transaction. These differences have been evaluated extensively in the professional literature and are not addressed here.

• A sale of assets to an existing dynastic trust is another technique to consider if there is little or no exemption remaining. The alternative will be an installment sale of business interests to a dynastic ‘grantor’ trust for a promissory note, a self-cancelling installment note (“SCIN”) or a private annuity. The recipient trust could be one established by the client/transferor (to create ‘grantor’ trust status), or a so-called Beneficiary Defective Irrevocable Trust (“BDIT”), or a Beneficiary Defective Trust (“BDT”) as others refer to it, established by a willing third party, such as a parent, and that is made to be a grantor trust for income tax purposes as to the transferor business owner.

• A taxable sale to a non-grantor trust is another possible consideration. While few if any clients may ever consummate a sale to an irrevocable trust that will generate income tax with a business interest, for a small number of clients this approach might actually prove advantageous if income and estate tax rates rise sufficiently in the future.

• The technique of a gift to a non-grantor incomplete gift trust, referred to as a “DING” or Delaware Intentionally Non-Grantor (“DING”) Trust has been used in the past to avoid state income tax prior to a large sale or public offering of a business. However, because of some questions as to whether such transfers might be viewed by the IRS as a completed gift, this technique has been shunned by many practitioners. Significant to 2012 planning, whether or not you believe the DING concept viable, is that it will not intentionally use any of the client’s exemption amount and therefore may prove a distraction from what history might prove to be more important estate planning steps.

• A few clients might actually consider making gifts of large business interests and incurring a gift tax. For example, a wealthy business owner that is terminally ill or quite advanced in age that believes the rate arbitrage of the current 35% gift tax will prove favorable as compared to the probability of a higher gift/estate tax rate in future years (whether 45% or 55%), or for whom the calculus of possibly excluding the gift tax from his or her estate weighs in favor of a current taxable gift.

• For those looking to take a walk on the wild side, perhaps a split-dollar loan of business interests could be considered.[3] The appropriate representations would have to be filed.[4] The parties to the split-dollar insurance arrangement would represent in writing that a reasonable person would expect that all payments under the loan will be made. Some commentators have stated that a split-dollar loan may be made in the form of property, not merely cash, relying on the Frazee case.[5] Under that theory, according to some practitioners, a business owner who has used his or her entire exemption could loan business interests to a trust to freeze value in his or her estate, and perhaps reduce the value of assets held in the estate if the split-dollar property loan can be discounted for estate valuation purposes.

The second category of client that may be put off by the communications focusing on gifting $5.12 million are the smaller business owners who might benefit handsomely from 2012 planning, but with much lower amounts involved. The focus on what they view as numbers well beyond their net worth (whether or not true, for many that is the perception) leaves the impression that 2012 planning is beyond their needs.

Example: Client is an entrepreneur in her mid-30s with a $2 million net worth, $1 million of which is her interest in her start up business. With an estate valued well below the $3.5 million exemption President Obama has proposed, her eyes glaze over when reading articles extolling the virtues of $5.12 million gifts. How can that ever apply to her?! The answer: Quite easily. If future economic recovery solidifies and inflation rises, to what value could her business blossom? If the use of grantor trusts in estate planning as we now know it is effectively eliminated as a result of the legislation proposed by the Treasury “Green Book” (since assets of non-grandfathered grantor trusts will be included in the grantor’s estate) and by the Obama administration (where transfers to all grantor trusts are deemed incomplete), the ability to capture tax “burn” in future years will be lost (e.g., where the income tax on the trust earnings burns up the estate without gift tax consequence). In addition, the flexibility to allocate generation skipping transfer (“GST”) tax exemption in perpetuity could be lost (there is a proposal to limit the number of years for which a GST allocation could be effective to ninety). These valuable planning opportunities may be lost even in smaller estates if no action is taken this year. If today’s small business grows to $5 million in the future, and the estate tax exemption becomes pegged at $3.5 million, grantor trusts, family business discounts and perpetual GST allocations are all restricted or eliminated, future planning options will be more limited Thus, planning today for business owners, with even smaller estates, may well be advantageous.

While generalizations are always limiting, there might be some benefit to practitioners in contrasting some of the differences in 2012 planning for a small estate such as that illustrated above and the planning for a very substantial business interest. Making this distinction, although admittedly somewhat arbitrary, may be useful to motivate smaller business owners to proceed with important planning. It may also facilitate more focused planning efforts for larger and smaller business clients given the time pressure to complete 2012 transactions.

Small versus Large closely Held Businesses Face Different 2012 Windows of Planning

What remains of 2012 can still provide a tremendous opportunity for closely held business owners of all sizes to plan to shift value out of their estate. There are a number of key tax and economic factors that would appear to make 2012 the optimal year to plan. The relevance and application of these ideas will differ from the small business and the much larger closely held business:

• Exemption: The present $5.12 million exemption[6] is the largest in history and is scheduled to drop to a mere $1 million in 2013. While no one without an Ouija board can predict where the exemption number will fall, failing to take advantage of the current large exemption may prove to be an opportunity lost. A significant reduction in the exemption amount will actually be a greater blow to small and mid-size closely held businesses because the mere size of the exemption can afford these clients simpler and less costly planning options. For a closely held business worth perhaps under $5-10 million a client might simply make a gift of up to $5 million of business interests to one of the many variations of a grantor dynasty trust (DAPT, SLAT, etc.). If the exemption does drip to $1 million in 2013 and ignoring for the moment other adverse changes, planning that could have previously relied on a single outright gift will now have to consider a sale or other technique to transfer the desired business interests to avoid gift tax on the value over $1 million. In contrast, for a large closely held business, the actual size of the exemption amount (whether $2 or $5+ million) has less impact on overall planning proportionate to other issues, since a more complex note sale technique (or other planning) would be necessary in 2012 or future years (assuming it is available in future years). So an important point to smaller business owners is to capitalize on the simplicity in planning the current large exemption affords. Too many don’t hear this planning message because the bulk of media coverage of the estate tax has remained fixated on the singular issue - the exemption amount.

• Interest Rates: Interest rates are at historic lows. As will be explained below, this is a critical factor for larger businesses owned by taxpayers with much larger estates. This is because business interests valued under $5.12 million can simply be gifted to an irrevocable trust without gift tax. Transfers of larger business interests must include a sale or loan component to shift meaningful equity out of the owner’s estate without incurring any gift tax. Locking in current historically low interest rates has important impact. For practitioners that believe it is safer to structure sale transactions with current interest payments, or even a modicum of principal amortization, it may only be at today’s low interest rates that the cash flow distributed from many business interests to the irrevocable trust/donee will afford the ability to make the required note payments. At higher interest rates the pressure on the cash flow from the transaction might make the transaction impractical, creating pressure on obtaining an aggressively low appraisal value or forcing the abandonment of principal amortization, and even requiring the accrual of interest. Many practitioners may view these consequences as increasing the risk associated with the transaction. Again, the media’s singular focus on the $5.12 million exemption obfuscates the importance of the current interest rate environment to planning.

• Grantor Trusts: At present, grantor trusts can be used effectively for estate tax reduction. However, President Obama has proposed eliminating the estate tax benefits that grantor trusts afford by treating gifts to all grantor trusts as being incomplete and included in the grantor’s taxable estate. When an irrevocable completed gift trust can be structured as a grantor trust for income tax purposes, it provides a host of valuable tax benefits for business owners. For all business owners it can permit the owner to deal with the trust and substitute other assets for the business interests thereby reclaiming the business interests. [7] Grantor trust status provides incremental estate planning by virtue of the fact that the business owner continues to pay income tax on all income earned by the grantor trust. This continues to reduce the business owner’s estate for tax purposes. For large estates, the availability of grantor trust status is essential to shifting large value business interests out of the owner’s estate. For owners of these valuable businesses, at least a portion of the business interests must be sold to the trust if the $5.12 million exemption is smaller than the value of the business interests involved, and the business owner is not willing to pay gift tax. Failing to plan in 2012 may make any meaningful future planning impractical. This is because the modifications that may occur to the grantor trust rules could cause the grantor trust assets to be taxable as part of the grantor’s gross estate. That disincentive would likely dissuade any business owner from proceeding with a future sale to a grantor trust.

• GST Exemption: President Obama has proposed limiting to ninety the number of years for which GST exemption can be allocated. This could adversely affect all business owners, but the larger the wealth transfers involved the more negative the impact. This would mean that transfers of valuable business interests that are anticipated to appreciate further in the future would eventually be brought back under the reach of the transfer tax system. Acting now, before such a change is enacted, could prove beneficial for all business interests, but clearly more so for many interests that may create estate taxes at every generational level given their size. Failing to take advantage of the possibility of grandfathering GST exempt trusts (and having those trusts in a state with a favorable trust law environment) could result in year 90 in half the value of the trust being dissipated by a future GST tax.

• Discounts: Discounts for lack of control, lack of marketability, etc. can be incredibly helpful in “leveraging” gifts to an irrevocable trust to grow outside of the owner’s estate. Discounts on active closely held business interests often are 30% and higher. That discount can effectively permit a business owner to transfer a much larger percentage interest in a business to a trust under the current $5.12 million level. Discounts in this context are quite beneficial, but for owners of a very large closely held business the benefits of discounts can be more dramatic, even essential to the viability of the transfer. As explained above, for business interests valued at more than $5.12 million the excess value has to be sold to the irrevocable trust since a gift of more than $5.12 million would trigger a gift tax at the current 35% rate which few business owners would be willing to bear.[8] When a large business interest is sold to an irrevocable trust, it is typically sold for a note which must bear interest at current rates. [9] For the trust to pay current interest, and possibly some principal amortization, the annual pro-rata distributions from the business to the trust meet the cash flow requirements. The availability of discounts can provide in some instances the critical leverage (the relationship between the value of the business for purposes of the sale and the cash flow the business distributes) to a make the economics of the numbers work. Without discounts, some transactions will simply be impossible to structure unless interest is accrued on the note rather than paid currently. For smaller closely held businesses this is also critical. According to some practitioners the accrual of interest in such a related party transaction might make the entire transaction more susceptible to IRS challenge.

• Values: For large and small businesses alike, if the current value of the business is low by historical standards, depressed by the current economic circumstances, etc. this may be the ideal time to shift the value of a business interest to an irrevocable trust so that future growth will be out of the owner’s estate. For smaller business interests that are well below the $5.12 million exemption there may be a tendency obtain an aggressive appraisal since the risk of a gift tax valuation audit adjustment is viewed as more remote than usually. For larger estates the value may be backstopped by a defined value clause (see below) may be the preferred approach For these transactions well beneath the gift tax threshold some practitioners might, even in the wake of the Wandry decision[10] (that authorized use of a defined value clause for the first time without the excess being transferred to a charity) remove the defined value clause because it could be viewed as another “bell and whistle” that may be perceived negatively on an audit. Other practitioners suggest that a Wandry clause should be included in most transactions with valuation risks under the chicken soup theory (“It can’t hurt.”).

Structuring the Transfer of Closely Held Business Interests to an Irrevocable Trust

There are several steps or mechanisms that should be considered by closely held business owners for all sizes of business interests in planning gifts to irrevocable trusts to remove growth outside of their estates:

• Sale for a Private Annuity: For all business owners, the restriction or elimination of grantor trusts might eliminate the ability to consummate sales for private annuities in light of the proposed Regulations which would trigger taxable gain on such transactions absent the sale to a grantor trust.[11] The proposed Regulations, when combined with President Obama’s proposal for grantor trusts, would eliminate the use of the private annuity technique. The proposed amendments provide that if an annuity contract is received in exchange for property (other than money), the amount realized attributable to the annuity contract is the fair market value (as determined under section 7520) of the annuity contract at the time of the exchange. Further, the entire amount of the gain or loss, if any, is recognized at the time of the exchange, regardless of the taxpayer's method of accounting. The only means of avoiding that current recognition of gain is a sale to a grantor trust. Thus, business owners near or at retirement who desires the certainty and benefits associated with a private annuity should give strong consideration to consummate their planning in 2012.

• Directed Trusts: This is a critical concept to make a transfer of business interests to an irrevocable trust viable. Historically, a trustee was responsible to make investment decisions. The result of this was that naming an institutional trustee for an irrevocable trust to hold interests in a closely held business was an anathema to almost every business owner. No business owner wants a bank or trust company managing their business. Likewise, few banks and trust companies would accept the potential liability of holding a concentrated position in a closely held business. More recently the Prudent Investor Act enacted in some form in most or all states permitted trustees to delegate investment management. This was helpful to permit a trustee to hire a specialized investment manager. For example, a bank that had investment expertise generally, but not in commodities or foreign securities, could make investments in most trust assets but delegate investment management for those two asset classes to other money managers with specialties in that specific area. However, the trust or bank delegating authority still had liability to oversee to some extent the activities of the manager to whom they delegated investment authority. For a closely held business, this continued investment risk would not suffice and institutions could not feasibly serve as trustees of trusts owning interests in closely held businesses. Several states have enacted statutes that permit trustees not merely to delegate investment authority, but to have investment authority “directed” by the trust instrument. The distinction between “delegating” and “directing” is tremendous. When a trust directs that someone other than the trustee be responsible for investment management, the trustee should have no liability whatsoever for the investment activities. This opens the opportunity to name an institutional trustee who can charge a much lower fee for being an administrative trustee, rather than a much higher fee that would encompass the liability the trustee would face for managing a closely held business. From the business owner’s perspective the entrepreneur, not the bank or trust company, can manage the business. This mechanism is critical for sophisticated trust planning for closely held businesses to be viable.

• Tax Reimbursement Clause: An issue which can be quite acute when significant business interests are transferred to a grantor trust is the future income tax impact on a sale of the business. If the business is sold or goes public, a potentially large capital gain will be realized. While the pro-rata portion of the sale proceeds will be received by the donee trust (i.e., in proportion to the equity interests held), the entire gain associated with the transferred business interest will be reported and the tax paid by the business owner/transferor. This could create, absent proper planning, an economic hardship on the business owner. One approach to mitigate against this risk is for the grantor trust agreement to include a provision that permits an independent trustee to reimburse the grantor for any income taxes that he or she is required to pay on trust earnings.[12] The trust, however, must have situs in a state whose laws would not result in this provision making trust assets reachable by the business owner/transferor’s creditors. If not, the inclusion of such a tax reimbursement clause may result in estate tax inclusion, thus defeating the entire plan. Proper trust situs, however, does not resolve this planning dilemma. If the grantor trust is designed to be estate tax effective (i.e. the trust assets are not taxed as part of the grantor’s estate), the grantor is required to bear the annual income tax cost on the trust’s earnings so that this tax “burn” continues to reduce the grantor’s estate. (i.e. reduction of grantor’s taxable estate via payment of income tax on the trust’s earnings). Having the trust reimburse the tax cost defeats an important component of the planning objective. The effective leakage of a large tax payment back into the grantor’s estate could negate years of prior grantor trust status. Reliance on this type of clause, however, potentially raises a more sinister tax risk. If a client transfers a large business interest into a trust and three years later when the business is sold the trustee reimburses the grantor for all income tax costs, the IRS might argue that the tax reimbursement ratifies the existence of an understanding that the grantor/business owner and trustee had planned that such a reimbursement be made. If that IRS challenge succeeded, the entire plan could be torpedoed and the entire value of the now highly appreciated business that was sold would be included in the now former business owner’s estate. There are other options. The trust could exclude such a provision to avoid any inference of an “arrangement” or prearranged plan. If in fact the grantor were cash strapped after a sale, the trustee could simply loan cash to the grantor to pay the tax. There should be no leakage of value back into the grantor’s estate because the loan represents a debt of the grantor’s estate. The range of interest rates that might be reasonable to use may afford a degree of planning flexibility to shift greater value into the trust. For example, if the restrictions on GST tax and grantor trusts are in fact enacted, paying a higher, but arm’s length interest rate may provide a legitimate and tax defensible means of shifting additional economic value into a grandfathered grantor dynasty trust when direct transfers to such a trust would no longer qualify. Additional steps can also be taken to mitigate against a cash flow problem. In negotiating the sale of many businesses there is often some latitude to structure some portion of the purchase as a consulting agreement to the grantor. While in most instances the seller would prefer payment for equity to qualify as capital gains rather than compensation that would be taxed at higher ordinary income rates, this might be an exception. If the grantor is in need of additional cash that could be factored, within reason, into the negotiating process. Compensation would be received directly by the grantor, and not prorated in proportion to equity interest ownership between the trust and the grantor. If the spread between ordinary and capital gains tax rates, especially for wealthier clients, is reduced in the future, the negative tax cost of this type of planning will decline. For many clients, the spouse will be a beneficiary of the trust involved (e.g., the so called “spousal access trust”). Reasonable distributions to the grantor’s spouse, in accordance with the terms of the trust, provide another conduit for cash to pay the tax cost triggered on sale. If the trust is structured as a self settled trust, the grantor/business owner will personally be a beneficiary and be able to receive discretionary distributions. Finally, for wealthier clients, there is often a second trust for the grantor’s spouse that could be in a position to make distributions and/or loans to fund tax costs. When GRATs are used in the transfer of closely held business interests, the client might choose to hold the remainder in a trust that is not characterized as a grantor trust. For example, if the client is confident that the business will not be sold for at least five years, and the GRAT term is pegged at five years, if grantor trust status ends with the end of the GRAT term, the remainder trust will simply bear its own income tax burden. While perhaps not optimal from a wealth transfer perspective, it is an approach that may find appeal for some clients.

• Power to Substitute: Most trusts that are setup to be the recipient of large gifts are intentionally structured as grantor trusts for income tax purposes. IRC Sec. 674(a) provides: “The grantor shall be treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income therefrom is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party”. However, for these so-called “control strings” to achieve grantor trust status the exceptions in IRC Sec. 674(b), (c), and (d) cannot apply. PLR 200846001. Grantor trust status will achieve “tax burn” via a provision in the trust which permits the substitution of high basis assets for low basis trust assets prior to grantor’s death to achieve a step up in basis for the heirs and to avoid capital gains tax on a sale by the Grantor of appreciated assets to the trust. For transfers of larger business interests, grantor trust characterization is essential. The inclusion of a power to substitute in the trust should not cause estate tax inclusion so long as the requirements set forth in Rev. Rul. 2008-22 are met. A concern specifically applicable to planning for transfers of closely held business interests is whether the grantor’s substitution power might be treated as an indirect retention of the power to control the voting of the stock under IRC Section 2036(b), thereby causing estate tax inclusion. More particularly, the question is whether a power to substitute that would permit the grantor/business owner to reacquire voting stock will be viewed as the equivalent of the retention of the right to vote (directly or indirectly) shares of stock of a controlled corporation within the meaning of section 2036(b). However, this would require the grantor to pay full and adequate consideration for the voting stock that he or she wants to acquire. Also, even assuming the Trustee was satisfied with the sufficiency of the consideration to be paid for the voting stock, the Trustee most likely has a fiduciary duty to avoid a situation where the grantor may be expected to vote the stock in question in a manner that is adverse to the Trust or its beneficiaries. An abusive application of the power to substitute could occur, for instance, if the grantor were to reacquire the voting stock shortly prior to an important vote and then return the stock to the Trust (in exchange for the original consideration paid) shortly following the vote. This type of abuse could give rise to a challenge that the entire transaction was a sham. But absent such abuse, should the mere power to substitute raise the specter of 2036(b)? Rev. Rul. 2008-22 explicitly held that a grantor’s nonfiduciary substitution power by itself will not cause estate tax inclusion under section 2036 or 2038 (which should encompass section 2036(b)). The Service made no attempt in the Ruling to exclude from its application stock of a controlled corporation under section 2036(b). Rev. Rul. 2011-28 provides that a grantor’s retention of a nonfiduciary substitution power with respect to insurance on the grantor’s life will not by itself cause estate tax inclusion under section 2042. While section 2042 obviously presents different issues, the rationale and pattern that it seems to infer toward substitution powers seems quite favorable. More than a few commentators believe that extending the concept of an indirect power to vote stock to the power to repurchase voting stock by paying full value for the stock is an unwarranted extension of the plain meaning of the statute.[13] For clients that remain concerned over the possible assertion of a 2036(b) challenge, they might be satisfied achieving grantor trust status by authorizing a non-adverse party to make loans to the grantor without adequate security, but with adequate interest. However, this approach is not without risks either. What amount or form of security would be considered inadequate? If the business owner has a substantial net worth (and should that be determined valuing notes used in the sale transaction at face or discounted value?), does the trust even have sufficient assets to make a large enough loan such that security of any sort might be needed? Perhaps the right to loan without adequate security could be bolstered with a provision permitting the addition of a charitable beneficiary. However, many clients might find such latitude to effectively change the dispositive provisions of the trust as unacceptable. Whether either or both of these latter approaches are used to secure grantor trust status, they have a significant disadvantage as compared to the use of the power to substitute. Many clients prefer the ability to substitute low basis trust assets, such as equity interests in the closely held business, for cash or other non-appreciated assets.

• Trust Situs: Many practitioners recommend that an irrevocable trust created to hold interests in a closely held business be established in Alaska, Delaware, Nevada or South Dakota, and selected other states, unless there is a compelling reason to the contrary. While other states have enacted favorable trust legislation in recent years, these four specific states have assumed the role of leaders in trust friendly environments. With respect to state income taxes as a planning concern, using any of these, or appropriate other states, will assure that the trust is domiciled in a state with favorable income tax laws that do not tax trust income accumulated for non-resident beneficiaries. Creditor protection laws of these states provide advantageous wealth protection laws as compared to other states, e.g., affording the fewest if any rights to exception creditors, such as divorcing spouses. The favorable creditor protection laws are also vital to achieving intended estate tax objectives. An extended rule against perpetuities is also advantageous, especially in light the proposal to limit the ninety (90) year term for which an allocation of a donor’s GST exemption will be effective. An extended perpetuities period is important in achieving effective asset protection for future generations. When the perpetuities period under applicable state law ends, trust assets must be distributed to current beneficiaries, which could place the distributed assets in harms’ way.

• Trustees: Many clients are reluctant to name an institutional trustee. But for clients not residing in one of the trust friendly jurisdictions, naming an institutional trustee in the desired jurisdiction may be necessary to create sufficient nexus. When planning for such a significant asset transfer the incremental cost of using an institutional trustee in one of these jurisdictions, especially as an administrative trustee for a directed trust, is modest. When planning for closely held businesses, the benefits of involving an institutional trustee can be more significant. An experienced institutional trustee can help mitigate against family disputes, add independence to help support the intended tax planning and asset protection results, facilitate succession planning, and more.

• Defined Value Clause: A defined value clause is a mechanism that endeavors to prevent triggering a current taxable gift on a gift or sale of hard-to-value assets, such as interests in a closely held business, to an irrevocable trust (or any donee for that matter)[14]. The mechanism is that a specified dollar figure of interests in the closely held business (which can also be framed as a formula tied to the donor’s then available exemption amount) is to be gifted (or sold) to the irrevocable trust. If the value of the business interests is later determined by the IRS to be greater than that determined in the qualified appraisal that the taxpayer has obtained (i.e., the value specified in the defined value clause as being transferred to the trust), the excess value will not be transferred to the trust, but rather will be redirected to a different person or trust that will not trigger gift tax (e.g., a zeroed out GRAT or a marital/QTIP trust, private family foundation, etc.). Some practitioners are concerned that with the significant victory by taxpayers in the recent Wandry case, the government may seek to curtail use of this technique.[15] Unlike the earlier cases, the Wandry court accepted a formula in which the amount of equity interests transferred was limited by the desired value; there was no excess interest redirected elsewhere.[16] In the meantime, the protections that a defined value clause can afford can be quite valuable in safeguarding transfers of hard-to-value business interests. This is especially useful when interests in closely held business are transferred where valuation issues can abound (e.g., what is the impact of risk of death or disability of the entrepreneur/founder of the business on the valuation). As noted above, there are widely differing views on the benefits and use of a Wandry approach; the IRS has already appealed the decision.

Ancillary and Implementation Considerations

There are a number of ancillary steps and considerations that should be addressed in the context of transferring business interests to an irrevocable trust:

• Opinion of Local Counsel: If the attorney for the business owner does not practice law in the state where the trust is established (e.g., a New Jersey attorney assisting a client to establish a trust in Alaska) consider obtaining an opinion of local counsel confirming that the trust is valid under that state’s laws.

• Lien and Judgment Searches: In some cases due diligence should be considered before the transfer of any significant assets to an irrevocable trust to corroborate that there are no current suits, claims, liens or other liabilities that might taint the transfer as a fraudulent conveyance. The business owner could sign an affidavit attesting to the lack of knowledge of any claims and a balance sheet confirming adequate resources remain in the business owner/transferor’s name after the transfer. Ideally, the business owner’s accountant and/or financial planner could prepare formal projections, or at least summary cash flow calculations, demonstrating that based on a current budget that the grantor has adequate resources without distributions from the irrevocable trust to the business owner or his or her spouse. Consideration should be given to performing web based lien and judgment searches and perhaps ordering title searches on real property to identify any outstanding issues, to demonstrate that none were known when the transfers were consummated.

• Status of the Entity: The governing documents for the entity should be obtained as well as a certificate of good standing. If there is an issue with the validity of the entity, it may affect the effectiveness of the transfer of interests in that entity to the trust.

• Legal Documentation Generally: The legal documentation for most closely held businesses is woefully inadequate. Many lack not only annual minutes, but any minutes, bylaws, or governing agreements (operating, partnership, and shareholder). Prior to any transfer to any irrevocable trust all legal documentation for the closely held business should be reviewed, updated and completed. Proper documentation should exist before and after any transfers to an irrevocable trust. For example, consider confirming that there is a valid governing operating agreement prior to the gift or sale of membership interests to the irrevocable trust. After the transfer, a revised amended and restated operating agreement should be executed reflecting the new owners and any provisions that are appropriate in the post transfer circumstances. Perhaps the operating agreement may be amended to add provisions concerning trust-members. This is also critical to protect the integrity of the business entity from claimants and creditors, as well as to have any likelihood of the IRS respecting the transaction. A common gap for many closely held businesses is documenting related party transactions. Any loans should be corroborated by written loan agreements. If property is rented by an operating company from a related real estate leasing company, an arm’s length commercial lease should be in place with a commercially reasonable fair market rent corroborated by an appraisal. An integral part of this legal documentation should be to incorporate succession planning provisions. Unfortunately, given the time pressure to complete 2012 planning many of these matters may have to be deferred to post-transaction 2013 follow up.

• Tax Reimbursement Clauses in Flow-Through Entity Governing Documents: Many governing agreements for flow through entities (e.g., operating agreements for limited liability companies, “LLCs”, and limited partnership agreements for family limited partnerships, “FLPs”) include a mandatory tax distribution clause. Similar provisions can be incorporated into S corporation shareholder agreements. With approximately 2 million S corporations still in existence, this remains an important consideration. The objective of all these clauses is to minimize the cash flow problems faced by the minority owner of a flow- through entity who must report taxable income attributable to his or her interest, but may not receive annual cash distributions from the entity commensurate with such income or even sufficient to pay the associated tax. These clauses appear in many formats, but a common approach is to mandate a distribution of a fixed percentage of taxable income. If there is no such clause, will the officers of the S corporation (manager of an LLC, or the general partner of a FLP), make reasonable distributions to the minority owners if the governing documents don’t require it? However, if such provisions are included in the governing documents of the business entity, they will reduce the asset protection benefits associated with the equity interests retained by the business owner. Also, such mandatory cash distributions may adversely affect valuation discounts.

• Crummey Power Type Provisions to Qualify for Annual Gift Exclusion. Some FLPs or LLCs include a provision analogous to a Crummey power that would afford a donee of an equity interest, a limited right to sell the interest received as a gift (or to “put” it back to the entity). This mechanism has been added to some documents to endeavor to qualify equity interest for the $13,000 (2012) annual gift exclusion. This assists to establish that the gift be of a present interest. This mechanism is meant to allow the donee to currently realize an economic benefit from the transferred interest.[17] The typical restrictions on transferability and distributions which many families insist on including in their FLP or LLC governing documents to keep equity within the family can be contradicted by these clauses. Further, some appraisers might view these clauses, depending on how they are worded, as adversely affecting discounts. However, most large gifts to an irrevocable grantor trust in 2012 will likely be made using the grantor’s applicable gift tax exemption rather than annual exclusions. Therefore, such Crummey type clauses appear in many cases to be unwarranted and revisions of governing documentation prior to gift or sale transfers may be worth consideration. Again, much of this will have to be weighed against the time pressure to complete 2012 deals.

• Personal Piggy Bank: Too many closely held business owners treat the companies, regardless of what form of entity, or how large it may be, as a personal piggy bank, using entity funds to pay personal expenses - and worse. These types of issues raise red flags for tax audits, and potentially undermine the integrity of the entity should a claimant endeavor to pierce the entity to have a claim satisfied from personal assets. While this type of conduct is never appropriate, it becomes even more susceptible to scrutiny, and potentially more damaging, when interests in such an entity are transferred to an irrevocable trust. The continued use of company funds to pay inappropriate personal expenses could make the transaction easy prey for an IRS agent seeking to include all of the transferred business interests in the taxable estate of the business owner who gave and/or sold business interests to the irrevocable trust. Spring cleaning is a vital step in the advance of any transfer. For future follow up on these 2012 transactions, because of the magnitude of many wealth transfers (in relationship to the clients overall wealth as well as in absolute terms) there may be a greater incentive in the future to capture perquisites from a business whose interests were transferred as part of a 2012 estate plan than for transfers typically made by clients in prior years.

• Reasonable Compensation: When entrepreneurs own 100% of a business entity they typically have little concern over the dollar amount of compensation they withdraw or when they withdraw it. This often remains true even if other family members own minority interests in the business. However, when a transfer is made to an irrevocable trust, the level of compensation can have a dramatic impact. If the compensation taken is egregiously low, the IRS could argue that the failure to take fair compensation constitutes an additional gratuitous transfer to the irrevocable trust. If such a challenge succeeded, it could have negative gift and GST tax consequences. The additional deemed transfers could trigger both gift and GST tax to the business owner. On the other hand, if compensation was egregiously high, the IRS could argue that the excessive compensation constituted a retained income interest in the business interests transferred that all such interests to be included in the business owner’s taxable estate upon death, thereby negating any planning. The client should be advised that, perhaps for the first time in the business owner’s career, his or her compensation will need to be pegged to a supportable arm’s length range. It might even prove advantageous to have an independent corroboration of the amount of fair compensation. Again, given time pressures these steps may have to be considered in 2013 well after the 2012 planning dust settles.

• Buy Sell Arrangements: Buy Sell agreements are commonly used in closely held businesses. Buy Sells can be structured as either redemption agreements with the entity repurchasing equity or as cross-purchase agreements with the other non-selling owners repurchasing equity. Combinations of both, or “hybrid” agreements are also common. Transferring equity interests to an irrevocable trust changes the dynamic of buy sell agreements, and in many instances may obviate the need for them. Life insurance that is often used to fund such agreements will need to be evaluated to ascertain whether it should be continued, modified, cancelled or transferred to a new owner. This occurs because the transfer of interests to the trust may, in some circumstances, obviate the need for a buyout since one or more irrevocable trusts, not individuals, may own the equity. Example: A family corporation valued at $18 million is owned 1/3rd by each of three siblings. They have a hybrid agreement with some life insurance held in the corporation that must be applied to repurchase shares. Shares not purchased by the corporation will then be purchased pursuant to a cross purchase arrangement. But if, after discounts, each sibling can transfer by gift their entire equity holding to an irrevocable family dynasty trust, the succession of shares may be handled within the trust provisions, and not through the redemption and cross purchase arrangements (this of course assumes that the family has decided not to buyout the interest of a deceased or otherwise inactive sibling and to allow the interest to continue to be held in his/her family trust). The existing buy sell agreements should be terminated as there will be no equity interests left to buy. Some portion or all of the life insurance on the siblings held in the corporation may be advantageous to retain as key person insurance to assist the corporation in the transition period following the death of a sibling participant. Insurance that is not needed might be transferred to the insured, but transfer for value and other rules should be considered. Insurance that had been held for use in the cross purchase arrangement may be transferred to the owner-insureds, but again the transfer for value and other rules should be considered. There may be the exception for “transferred to the insured” that should apply. If the transfer for value rules are triggered, insurance proceeds could, in whole or part, be subject to income tax.[18] The instances in which a life insurance policy is deemed transferred for something of value is broader than often anticipated and the rules are technical, such that the “transfer for value” rules present a trap for the unwary. There are a number of exceptions to the transfer for value rule, including a transfer to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. A transfer to a corporation in which the insured is an officer or shareholder will not trigger the transfer for value rules. However, a mere nominal officer or shareholder may not qualify for this exception.[19] The reverse transaction, however, may not be covered. It is important to bear in mind in that a transfer from the corporation of an insurance policy to a shareholder will not avoid the transfer for value rule, unless that shareholder meets another safe-harbor (i.e. the recipient shareholder is also the insured under the policy). This situation may be addressed with the use of a bona fide partnership among the shareholders that has an independent and valid business purpose. A transfer to a partner of the insured, on the other hand, can be tax free and avoid the transfer for value rule. [20] To obtain a greater measure of safety in avoiding unintended transfers, or deemed transfers under the transfer for value rule, it may be advisable for all of the shareholders to also operate a partnership, as partners, such that this exception can provide a possible fallback position in the event any of the contemplated transfers were to inadvertently violate the transfer for value rules. Another exception to the rule includes a transfer of a policy to a partnership in which the insured is a partner. [21]

• Acknowledgement of Exercise or Non-Exercise of Powers: From an operational perspective the sophisticated trusts used in this type of planning present ongoing operational issues that may be significantly different from the operational aspects of, for example, a typical life insurance trust. The life insurance trust should maintain a separate bank account, issue Crummey notices, etc. Most practitioners are well familiar with the ongoing maintenance of such trusts. The complex trusts typically used in large dynastic gift and sale transactions often contain a number of different powers and fiduciary provisions that might have significant impact on the trust. For example, if there is a power to substitute assets, add a charitable beneficiary, make a loan without adequate security, or even all of these, can the accountant preparing an income tax return for the trust, or an attorney evaluating the impact of a legal question, properly advise the trustee without knowledge as to whether these events have, or have not, occurred? Consideration should be given to periodically having the various power holders execute statements acknowledging whether or not they have in fact exercised any of the powers granted. There is a very wide diversity of practices amongst professional advisers in regard to post-gift/sale follow up. Likely as the massive 2012 transfers are subjected to audit and some wind their way through the court system in future years, more guidance as to appropriate steps may come to light.

There are a host of other general considerations that might apply depending on the circumstances of each business owner, the goals involved and the nature of the trusts and gifts contemplated.

Types of Trusts that Might be Used

While most practitioners are well familiar with the various categories or general types of trusts used in this type of planning, there might be some benefit to quickly summarizing them and highlighting some of the specific issues and considerations when the different types of trusts are used in planning for larger transfers of closely held business interests:

• Domestic Asset Protection Trust (“DAPT”): A DAPT is a self-settled asset protection trust the distinguishing feature of which is that the business owner/transferor is also a discretionary beneficiary. Assets transferred, such as the business interests, are intended to be removed from the reach of creditors and from taxation in the business owner’s estate. In a recent case, the creditors of the grantor were permitted to reach assets held in an Alaska asset protection trust.[22] However, most practitioners note that the plan design and administration of the trust in that case was far from optimal. Moreover, the person setting up the Alaska trust had filed for bankruptcy protection, thereby exposing the trust assets to the state’s bankruptcy rules. So, while there remain naysayers, it would seem reasonable to say that most practitioners believe that there is merit to the use of DAPTs in the right situation, although this approach is not free of uncertainty. Again, as with so many sophisticated planning techniques there is a wide diversity of views amongst practitioners. Some are adamant that the self settled trust concept is viable and should be respected. The absence of any real case law on point to the contrary in the many years that domestic self settled trusts have been used should not be underestimated. The real driver, however, for many DAPTs is the sheer terror many clients feel at the thought of transferring significant wealthy completely out of their reach. While the “super wealthy” (however that is defined) don’t need to remain beneficiaries of trusts to which they make gifts, the mere “wealthy” (again, defined from the client’s emotional perspective, not objective economic analysis) will often insist on access to funds transferred as a precondition to transfer.

• Dynasty Trust: Dynasty trusts are always set up as completed gift trusts and, ideally, are set up to maximize the generation- skipping transfer (“GST”) tax benefits. Dynasty trusts are primarily established for estate tax planning purposes, rather than asset protection for the business owner. While many, and for some practitioners nearly all, trusts are structured to be dynastic in nature to the extent GST exemption is available, “dynasty trusts” in this article are intended to refer to non-self settled trusts. These trusts can, however, provide meaningful asset protection benefits in some instances. If, for example, a business endeavor or real estate investment is held in a single member LLC, a transfer of a significant percentage of that entity to the dynasty trust should provide charging order protection to the formerly single member disregarded LLC. The transfer of membership interests to the dynasty trust as a second member will be transformed by the gift into a multi-member partnership. Thus, assets retained by the client/grantor can be brought under an asset protection umbrella without transfer to an irrevocable trust.

• Beneficiary Defective Irrevocable Trust (“BDIT”): Instead of the business owner establishing a trust for himself/herself, a benefactor, such as a parent, can establish a trust for the benefit of the business owner. The grantor/transferor/donor to the trust is not treated as the “grantor” for income tax purposes, but rather the business owner/beneficiary becomes, via the Crummey withdrawal mechanism, the grantor of the entire trust for income tax purposes. This may be achieved by assuring that the grantor/transferor/donor does not retain any of the powers typically used to create a defective grantor trust. The trust beneficiary should have an appropriate Crummey withdrawal power over all gifts to the trust. For a business owner who is married, having a parent set up a BDIT (“BDT” to some practitioners) to which business interests are then sold, may provide a safer approach as the business owner does not transfer any marital property by gift to the trust. For this planning to work, however, it is critical that the business owner not be treated as having transferred, either directly or indirectly, any property to the BDIT by way of gift. BDITs, similar to DAPTs, are subject to varying opinions. Some practitioners view the technique as assured and relatively straightforward. Some practitioners express considerable discomfort and have avoided the use of this approach. There is vast ground in the middle where differing use of fiduciaries (e.g., whether or not and in what capacity and degree a client/child can be named), the powers or rights to assure grantor trust status (use of a crummey power or according to some inclusion of a HEMS withdrawal right), and so on, make for wide variations. The key point is that there are many views on each of the sophisticated trust techniques and clients too often not only confuse the techniques but misunderstand the risks different techniques and applications may create.

• Combinations: One of the issues that will affect many wealthy families is that each spouse may establish a separate trust that includes the other as a beneficiary. This type of planning may raise the issue of the reciprocal trust doctrine. When endeavoring to differentiate the two trusts, if each trust is designed using a different format, e.g. one is a DAPT and one a BDIT, the risk of the IRS successfully applying the reciprocal trust doctrine should be minimized. It is important to note that hat gifts to these types of non-reciprocal or “spousal access trusts” will not likely qualify for the special spousal rules for “gift-splitting” allowed in IRC 2513. Mixing and matching different planning techniques can also better achieve client financial and personal goals and may avoid putting all of the client’s tax planning eggs in a single planning technique basket. While an array of different trusts might clearly afford a hedge in tax risk, more flexibility, etc., the increased cost and complexity unfortunately dissuades many clients from pursuing what they view as an alphabet soup of planning approaches.

Why, and How Smaller Closely Held Businesses Should Act Now

Owners of smaller businesses may be able to take advantage of the current $5.12 million exemption to transfer some or even all of their business interests outside their estate in a manner much simpler than the note/sale transactions that would have been required with a mere $1 million gift exemption. For example, if a business owner has business interests valued at $5 million, and $3.5 million net of discounts, a simple gift of the entire business to an irrevocable trust might suffice to remove the value of the entire business from the owner’s taxable estate. All future appreciation of the business can be removed from the transferor’s taxable estate with this one relatively simple step. If the stock is S corporation stock, special care should be considered to protect the “S” status of the corporation. Common mechanisms include a grantor trust, QSST or ESBT. However, if no action is taken in 2012, and even if the gift/estate tax exemption drops to the $3.5 million proposed, if discounts are legislatively prohibited for related party transfers, and if the gift tax exemption drops to the $1 million level it had been at for many years, transfers would become impossible by way of a simple gift. Instead, even a moderately sized closely held business would have to resort to a more costly and complex note/sale transaction as was the case before 2011. As noted above, this may not be feasible if the cash flow from the business after fair compensation to the owner and possibly without the benefit of discounts will not suffice to cover current interest payments due on the note. Moreover, it may not be feasible if there are other minority owners in the company. If the economy becomes stronger before the transfer planning is implemented, increases in both entity value and the current low interest rate could exacerbate these issues.

For owners of smaller business interests, especially if their personal wealth is largely tied up in their business, care must be taken to corroborate that there are adequate resources still available to the business owner after the transfer to support living and other expenses. For smaller estates, the transfer of large dollar values to an irrevocable trust, even if structured as a self-settled trust of which the business owner can be a discretionary beneficiary, could be problematic. As the size of the estate grows, greater assets are often retained in the business owner’s name so that this may be less of an issue. Some sensitivity analysis should be completed. For example, if the business owner becomes disabled, compensation from the business may cease. Are there adequate resources to enable the family to maintain the lifestyle to which it has become accustomed? Can the purchase of business interruption and disability insurance fill this gap? Can a compensation arrangement be implemented to provide for continued payment to the business owner of a partial or full salary in consideration of past services? Will Section 409A create issues with this type of plan? If two trusts are to be established for each of a husband and wife, and the business owner’s spouse transfers business interests to his or her trust, and the couple subsequently divorces, how will each be able to fare financially?

In some situations over zealous taxpayers, or overly aggressive advisers, may push transfers to irrevocable trusts that under various possible scenarios could render the family financially insecure. Changing the structure of compensation, using a self-settled trust instead of a so-called non-reciprocal trusts of which the business owner or spouse are a beneficiary, and other steps might be necessary to make the plan economically viable for the family. This is vital not only to assure the family that they will not have a financial hardship, but will also help support the reasonableness and validity of the transactions for tax and creditor protection purposes .

Why, and How Larger Closely Held Businesses Should Act Now

As the value of the business increases, the steps necessary to structure the transfer of business interests may change. While considerations similar to those discussed above for smaller business interests may continue to be relevant, a new range of issues arises.

Once the value of the business exceeds the $5.12 exemption, the transaction will more likely have to be structured as a part gift/part sale. The gift component of the transaction will likely have to be limited to the grantor’s available exemption amount so as to avoid incurring current gift tax. In some instances it may be feasible for the spouse to join in making the gift to a single trust (so called “spousal gift-splitting”) to increase the potential gift to $10.24 million. However, if gift splitting is desired, the spouse electing this treatment should not be a beneficiary of the donee trust. This will eliminate this approach for some, but not all business owners. The value of the business interests in excess of the available exemption will have to be sold to the trust which will freeze the value of those interests for estate tax purposes and shift future appreciation to the irrevocable trust.

If a gift of business interests (often referred to as a “seed gift”) is made to the irrevocable trust and additional interests in the same business are thereafter sold to the trust, the IRS may assert the step transaction doctrine.[23] Successfully invoking the step transaction doctrine might recast the gift followed by repayment as a down payment as an aggregated transaction thereby undermining the discount on the initial gift and the later sale to the trust. This might jeopardize the economic substance of the transaction. For example, if the client desirous of transferring a 55% interest of a business first seeded the gift to the trust with a 5.5% interest followed by a sale of 49.5%% - each independently eligible for discounting - aggregating the two components would undermine any discount. The preferable approach, if feasible, is to gift interests in different businesses or different assets than the primary business interests sold to the trust. This should minimize the likelihood of the IRS collapsing the gift and sale into one transaction that could adversely affect the characterization of the component steps in the transaction. A common approach is to gift interests in a real estate LLC that owns property leased to the business as the seed gift. Later, sales of interests in the operating business can be made to the trust. The reality for many planning scenarios is there is only a single business asset to transfer or contractual restrictions may prevent the use of other assets. While in prior years the seeding of a trust followed by a sale could be spread over some time period, even different tax years, the compressed time frame of what is left of 2012 will not afford such planning luxuries. So to complete planning, practitioners will in 2012 have little choice in many cases but to seed a trust with the some entity interests that will shortly thereafter be sold to the same trust.

As noted above, for wealthier families it becomes more common to establish two separate trusts, one for the business owner and one for his or her spouse, because the larger wealth may justify using both spouses’ exemptions to shift wealth out of the estate and by doing so the inability to qualify for spousal gift-splitting no longer presents a problem. For example, the business owner may gift $5 million worth of business interests to an irrevocable trust, and the spouse may gift $5 million of marketable securities, real estate or interests in other family assets to another trust. If this is done, the step transaction doctrine and reciprocal trust doctrine should be considered. Typically granting one spouse a limited or special power of appointment over the trust – and not the other - should suffice to blunt the impact of the reciprocal trust doctrine.[24] The step transaction doctrine could be used by the IRS to challenge a transaction if the business owner spouse gifts business interests to the non-business involved spouse, who in turn immediately gifts those interests to his or her own irrevocable trust. The IRS might assert that the initial transfer to the spouse was an inter-dependent step which could be disregarded, thereby causing the transfer of business interests to the non-business involved spouse’s trust to be treated as having been made by the business owner spouse, and subject to both gift and GST tax. The reciprocal trust doctrine could be applied by the IRS to unwind each trust and treat the business owner spouse as if a transfer was made to a trust of which he or she were a beneficiary and hence included in his or her taxable estate. Similarly, the spouse’s trust could be unwound and treated as included in his or her taxable estate.

Conclusion

Practitioners should be encouraging clients to address significant gift planning in 2012 before potentially adverse changes in the tax law are enacted and today’s favorable exemption amount and interest rates disappear. For clients owning interests in closely held businesses, planning could be even more important in order to safeguard the business for transmission to future generations. Planning for closely held businesses involves modification of the transfer documents, planning and ancillary steps. The complexity and risks of the massive business transfers that are likely to occur in the waning days of 2012 are significant, but for clients seeking to take advantage of what might be the last great wealth transfer opportunity, proper planning to minimize the risks and the inherent complexity may be well worth the endeavor.

CITE AS:

 

LISI Business Entities Newsletter # 133 (October 31, 2012) at    Copyright 2012 Leimberg Information Services, Inc. (LISI).  Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.

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[1] See IRC Section 671 et seq.

[2] See IRC Section 1361

[3] Treas. Reg. Sec. 1.7872-15(a)(2)(i).

[4] Treas. Reg. Sec. 1.7872-15(d).

[5] Frazee v. Commissioner, United States Tax Court 98 T.C. 554 (1992).

[6] Assuming no prior taxable gifts that diminished the exemption still available.

[7] While some practitioners raise the issue as to whether or not the power to substitute will raise 2036(b) estate inclusion issues for voting stock that conclusion is not fully clear and is beyond the scope of this article.

[8] While in some instances it might prove valuable to make taxable gifts in 2012 to incur tax at 35% if in fact the rate increases to 55% in future years, it will be assumed that few taxpayers would be willing to do so, and that further analysis of this planning to take advantage of possible rate arbitrage is beyond the scope of this article.

[9] While sales can be structured for private annuities or self cancelling installment notes (“SCINs”) the impact of discounts will have a similar affect.

[10] Wandry v. Commissioner, T.C. Memo 2012-88. (March 26, 2012) which the IRS has recently appealed.

[11] IRS News Release (IR-2006-161), Proposed Rules (REG-141901-05) On Tax Treatment of Exchanges of Appreciated Properties for Annuities.

[12] See Revenue Ruling 2004-64, Example 3.

[13] “Creating Intentional Grantor Trusts,” 49 Real Property, Trust & Estate Law Journal, Akers, Blattmachr & Boyle.

[14] Petter v. Commissioner, 653 F.3d 1012 (9th Cir. 2011).

[15] Wandry v. Commissioner T.C. Memo. 2012-88.

[16] See Petter Id. In Petter the donor gave away the entire interest and left a portion to the donee and any “excess” value to charity.

[17] Hackl v. Commissioner, 118 T.C. 279 (2002), aff’d 335 F. 3d 664 (7th Cir. 2003); Price v. Commissioner, T.C. Memo 2010-2; Fisher v. Commissioner, 105 AFTR 2d 2010-1347 (DC Ind. 2010).

[18] IRC Sec. 101(a)(2).

[19] Rev. Rul. 80-314, 1980-2 CB 152.

[20] IRC §101(a)(2)(B).

[21] IRC §101(a)(2)(B).

[22] Alaska, Battley v. Mortensen, Adv. D. Alaska, No. A09-90036-DMD, May 26, 2011 (Original Memorandum) and July 18, 2011 (Memorandum Denying Motion for Reconsideration).

[23] Redding v. Comm'r, 630 F.2d 1169, 1175 (7th Cir. 1980), certiorari denied, 450 U.S. 913. See also, Pierre, Suzanne J. v. Comr., TCM 2010-106.

[24] Estate of Levy v. Commissioner, 46 T.C.M. 910 (1983).

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