Since so few clients have estates subject to federal estate tax ($10.5M+ for a couple) income tax has really become the focal point of estate planning, trust management and estate administration. The good news for CPAs is, this is “right up their alley.” In fact, for astute practitioners this change in tax focus could shift significant estate planning from attorneys to CPAs. This article will give you a tool to begin capitalizing on this change.
√ 754 Elections
With so few clients subject to federal estate tax, and with the marginal state estate tax in decoupled states at a 16% rate, the capital gains costs (20% federal capital gains + 3.8% Medicare tax on passive income + state capital gains costs) will exceed the estate tax costs for most clients under the federal estate tax exemption levels. So maximizing tax basis on the death of a client will be the post-mortem planning focus. For partnerships, and limited liability companies (LLCs) taxed as partnerships, the inclusion of interests in the entity in the decedent’s estate will qualify those interests for a step up in income tax basis to the fair value of those interests on death. However, that alone will not provide the tax results sought. If the partnership (LLC) also makes an election under IRC Sec. 754 to adjust the inside basis of the decedent’s share of FLP/LLC assets, then the decedent’s “interest” in those assets will be determined (stepped up) as of the date of the decedent under IRC Sec. 1014. The tax basis needs to be compared to the fair market value of all FLP/LLC assets as of the date of the decedent’s death to determine whether the 754 basis adjustment should be elected. Assuming that it would be advantageous for the FLP/LLC to adjust the deceased client's basis on death (or any other event permitted under applicable law), there must be a basis for authorization of the election under Code Section §754 and §743 (b) to be made under the governing legal document (partnership agreement for the partnership or the operating agreement for the LLC). If the terms of the governing agreement don't mandate that the election must be made, or give a partner/member the right to demand that it be made, the basis step up may be only of academic benefit. However, the partner/member may be able to request that the partnership/LLC make the election. That might require a negotiation process and payment from the partner/member. In all events the conditions of the governing agreement must be complied with unless waived. The basis adjustment under IRC Sec. 743(b) is generally not reflected in the member's capital account. Treas. Reg. Sec. 1.704-1(b) (2) (IV) (m). The bottom in many cases will be that unless the deceased partner/member’s estate has the clout to push the election be made, absent an agreement mandating it, the entity may not comply. Given the significant importance of this election it may be advantageous to negotiate rights to insist on the election in advance. In that way, none of the other partners/ members know who will be the one benefiting from the election (it might be their estate) so that the dynamic of the negotiation will be different than what an individual deceased partner/member will face when it is only his or her estate that will benefit.
√ Entity Discounts
For many years practitioners have endeavored to maximize valuation discounts for gift transfers and the value of interests in any assets included in a client’s estate. A key component of the documentation of many gift plans, and estate tax returns, has been the formal appraisal of the discount applicable to the non-controlling interest in an asset or entity involved. The IRS has often challenged discounts as excessive. Post-ATRA the vast majority of clients will not face a federal estate tax. Discounts for these clients will not provide any estate tax benefit whatsoever, but they will reduce the value of the basis step up and thereby increase the future capital gains costs the client’s heirs will face. So in marked contrast to past practices practitioners may now be on the side of the table the IRS had previously occupied, arguing for lower discounts. In instances when a client owns an interest in an entity, for example, and discounts won’t benefit the client’s estate, it may be advantageous to recommend that the client discuss with the attorney for the entity whether and how the entity governing document (e.g., partnership agreement for a partnership, shareholders’ agreement for a corporation or operating agreement for an LLC) can be amended to minimize discounts. For example, if a member is permitted to sell his or her LLC interest to the LLC for the fair market value of that interest determined without discounts, then arguably there might be little or no discount as the interest is liquid at its fair value. However, these types of changes may not be agreeable to other members if their estates are large enough to face a federal estate tax. Also, some of the changes in the governing document that might vitiate discounts might also emasculate asset protection benefits. Other equity owners may object to such changes on those grounds.
√ QTIP Funding and Discounts
In post-mortem planning the determination of how to fund various trusts, and which assets to use to fund those trusts, has new importance and different nuances, post-ATRA. Consider a decedent that owns 100% of the interests in a family S corporation. Assume that the decedent’s estate values that interest at $2 million and that the client lives in a state that has a $1 million state estate tax exemption. On the client’s death $1 million of S corporation interests may be distributed to a state only bypass (exemption or credit shelter) trust to endeavor to minimize state estate tax on the death of the surviving spouse. This has always been rather common planning. The remaining $1 million or 50% interest in the S corporation stock is transferred to the marital or QTIP trust formed under the deceased client’s will. Clearly the value of the S corporation stock in the client’s estate is worth $2 million. However, if $1 million or 50% went to the QTIP trust, the IRS could argue that under current law the value of that 50% interest is less then the 50% of the $2 million value because it is a non-controlling interest that must be discounted. That discount would reduce the marital deduction to less than $1 million and thereby result in a gross estate that may not be fully offset by the marital deduction. Under prior law, depending on the exemption level, that could have resulted in a federal estate tax because of the disparities in value resulting from the discount. Under the post-ATRA structure there may be no estate tax involved because of the high exemption. However, for an estate that transfers, as in the preceding example, a percentage of an entity to a bypass trust and a percentage to a QTIP or other marital trust (all of which may remain common planning in decoupled states) the discount would reduce the income tax basis step up regardless of whether or not there is any estate tax implications to the discount. Might the IRS argue positions like this on future income tax audits?
√ QPRTs
Qualified Personal Residence Trusts (QPRTs) have been commonly used for many years to leverage the value of a personal residence, a home, and future appreciation in that home, outside a client’s taxable estate. The concept can be illustrated with an example. The client made a gift to a trust and reserved the right to live in the home for some specified number of years (the longer the number of years the greater the discount on the value of the future gift to the heirs). If the client survived the number of years used in the formula to calculate the gift then the value of the house would be removed in its entirety from the client’s taxable estate. The dilemma faced by many clients who created QPRTs in the past is that with the substantial increase in the estate tax exemption many (perhaps most) of the client’s that created QPRTs won’t face a federal estate tax. Thus, there may be no federal estate tax benefit from the technique. But the result is that if the house value is removed from the client’s estate the house won’t qualify for a basis step up on the client’s death. Since in many if not most cases the heirs will not use the house as a principal residence, they will not qualify for a home sale exclusion. Thus, when the heirs sell the house there will be the potential for a significant capital gains tax to be incurred. Planning after the end of the QPRT term (the number of years the benefactor, typically the parent, reserved to live in the house before title transfers to the heirs or a trust for the heirs) may be the opposite of what it has historically since the tax objective has become maximizing basis for clients not subject to a federal estate tax. In the past, following the QPRT term, the title (ownership) of the house would have been deeded by the client’s attorney to the heirs (or trust for them, whatever the QPRT document provided for). The parents/benefactors would sign a written arm’s-length lease and pay a fair rent to continue using the house. This was all done to minimize the risks of the IRS arguing that the parents/benefactors retained an interest in the house under Code Section 2036. Properly done this would enhance the likelihood of the QPRT plan being respected and the house being removed from the parent’s estate. However, that would assure that the house would not qualify for a basis step up either. Since most clients won’t face an estate tax, minimizing the potential capital gains costs to heirs will be the priority. That may be achieved by endeavoring to include the house in the parent’s estate. If the heirs sign a lease for life, payable at $1/year with the parents, that may suffice to force estate tax inclusion, at no federal estate tax (assuming that the parent’s aggregate estates remain under the available estate tax exemptions with consideration to portability).
√ Appraisals
For many years, perhaps decades, the focus of gift and estate valuations was to support the lowest feasible/reasonable valuation to minimize transfer taxes. Now, however, with permanent high exemptions and portability, many clients will never face an estate tax on the federal level. For clients domiciled in states that have decoupled from the federal estate tax they may face a state estate tax but no federal estate tax. Thus, the optimal (not legitimate) valuations for clients would fall into the following categories. In all instances understanding the optimal appraisal target must give way to the legitimate fair value of the assets being appraised. The key point is that the appraisal paradigm is dramatically different post-ATRA.
- Clients over the federal estate tax exemption – minimize values to minimize federal estate tax (and state estate tax if applicable).
- Client’s under the federal estate tax exemption but over their state estate tax exemption. This is a tougher call as it will require an analysis of the marginal tax impact of the state estate tax compared to the possible capital gains tax savings to the decedent’s heirs. Considerations of marginal tax rates, anticipated holding periods, whether tax free conversion options exist (e.g., a 1031 tax deferred like kind exchange), etc. will all have to be factored into the analysis.
- Clients under the federal estate tax exemption but domiciled in a state that does not have a state estate or other death tax. For these clients maximizing the valuations of all estate assets so long as the client’s estate remains under the federal exemption will provide the heirs with the most favorable tax basis/capital gains result at no estate tax cost.
- Clients under the federal estate tax exemption and under their decoupled state’s estate tax exemption. For these clients maximizing the valuations of all estate assets so long as the client’s estate remains under the state estate tax exemption (which is always less then the federal exemption) will provide the heirs with the most favorable tax basis/capital gains result at no estate tax cost.
√ Decoupled States and Bypass Trusts
In the past bypass trusts were often funded with assets most likely to appreciate. Now, post-ATRA, however, that may not be the optimal strategy since the assets in the bypass trust will not be included in the surviving spouse’s estate (generally, see below). Therefore, those assets won’t qualify for a step up in income tax basis on the second death. So, in contrast, to what may have been typical planning prior to ATRA, it may not be advisable for clients to fund bypass trusts when the family won’t face a federal estate tax with maximally appreciating assets. For example, the client’s bonds or other income assets may best be held in the bypass trust and equities most likely to appreciate in the marital trust or by the surviving spouse. In that way, all the assets without appreciation potential will remain removed from the estate, while those with appreciation potential will be included in the surviving spouse’s estate to qualify for a basis step up. There is an important exception to this planning approach which practitioners must be careful to consider. If the provisions of the bypass trust permit distributions of principal to the surviving spouse, then perhaps appreciated assets can be distributed to the surviving spouse prior to death and qualify for a basis step up. In such instances the planning approach may differ. This is not necessarily a simple determination. Will typical and general language in a bypass trust that permits principal distributions permit distributions of appreciated assets? Some bypass trusts in the future may specifically address this issue, many may not. If in doubt practitioners should recommend that the client have their estate planning attorney make this determination so that the client and other advisers will know how to proceed.
√ Existing Bypass Trusts
Many clients have existing bypass trusts formed on the death of a spouse. When those trusts were planned and funded the exemption amounts may have been much lower and there would have been an anticipated estate tax savings from the effort. Now, the client may be saddled with the costs of administration, including annual trust income tax returns, and no anticipated estate tax benefit. In some instances, it may be advantageous if the terms of the trust permit to distribute out some or all of the principal so that those assets will be included in the surviving spouse’s estate and obtain a basis step on the second spouse’s death. Other assets may be beneficial to be left in the trust earning income, especially if the trust is broadly drafted to include descendants as beneficiaries. In many cases distributions from bypass trusts are only made to the surviving spouse when in fact other family members are permissible beneficiaries. In such instances it may be beneficial to re-examine who are permissible beneficiaries and make distributions to family members in the lowest tax bracket. If the trust only permits the surviving spouse to be a beneficiary during his or her lifetime, it may be possible to transfer the existing bypass trust into a new bypass trust (a process called decanting). Alternatively, if the exemption is so large relative to family wealth it may be possible to distribute assets to the surviving spouse and have him or her contribute by gift those same assets to a new trust designed to take better advantage of the new income tax environment. Be cautious that the potential tax benefits not be pursued without due consideration to all other relevant factors: What does the trust provide? Who are the beneficiaries of the trust? Are they the same as the beneficiaries of the surviving spouse’s estate? Will the beneficiaries agree to a change in distributions that maximizes income tax benefits but that is different than historical distribution patterns? What type of liability exposure does the trustee face under each course of action?
√ Partnership Closing of Books
When a partnership (or LLC taxed as a partnership) must close its taxable year, such as on the termination of a partner during the year, the economic results of the partnership must be allocated for that partner to the time period prior to the closing of the FLP/LLC books, and to the period after the closing. There are two methods that can be used to make this allocation the interim closing of the FLP/LLC books, or the pro-ration method. Treas. Reg. Sec. 1.706-1(c)(2)(ii); Richardson v. Comr., 693 F.2d 1189 (5th Cir. 1982). The selection of which method can be used may have significant tax and economic impact on the partners/members and may depend on the language of the governing partnership or operating agreement. Since ATRA has increased the progressivity of the income tax rates so that the differential between high tax bracket partners/members and those in lower brackets may be more significant than in many years, the method selected should, in the family partnership/LLC context, be the one that shifts the most income to the lower bracket members/partners.
Under the interim closing of the books method, the books of the FLP/LLC are closed (as to the partner in question) and all items occurring before the date of closing are allocated to the partner/member who was the partner/member prior to the closing. All items of income, expense, gain or loss occurring after the closing of the books inure to the partner/member holding the interest after the closing date. The pro-ration method presumes all income, expense, gain and loss was earned equally throughout the tax year.
Martin M. Shenkman, CPA, MBA, PFS, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.
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