January 2009

In This Issue

• Thinking about transferring wealth to the next generation? Now is the time!
• Family Limited Partnerships are Still Viable

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Thinking about transferring wealth to the next generation?  Now is the time!

By Eric D. Duffee

Each morning's newspaper seems to bring a new level of despair: real estate values are in a free fall, stock markets have plummeted, unemployment rates skyrocket, and credit markets continue to tighten.  In light of the "doom and gloom" that surrounds us, it's hard to imagine that there is a silver lining, but for clients who are thinking about transferring some of their assets to the next generation, now is the perfect time to implement a strategy.

You might think of the current environment as a "perfect storm" for executing a new wealth transfer plan:

1. Valuations are Low.  Although it's somewhat hard to grasp, low valuations are actually a good thing when dealing with wealth transfers.  Because the fair market value of an asset as of the date of transfer is used in determining the existence and amount of a taxable gift, clients have more flexibility to transfer more investment assets at a lower cost. 

• An Example.  For example, say you owned 10,000 shares of JP Morgan stock.  When those shares were trading at $50/share, you could have done one of two things: (1) sold the stock to your children at the fair market value of $500,000 with no gift tax, or (2) gifted the stock outright and pay gift tax on the full $500,000 gift (with some reductions for annual exclusions, unified credit, etc.).  Today, assuming a $25/share value, you can transfer those same 10,000 shares for $250,000, either by sale or gift.  So, if you made an outright gift today, the gift tax savings would be approximately $125,000, or 50% of the $250,000 reduction in the valuation.  Even if you have "unified credit" remaining so that your gift is not taxable, you would have preserved more of your unified credit for later use.
• Complex Planning Strategies.  Lower valuations also facilitate the use of more complex estate planning strategies that are designed to "freeze" the value of your taxable estate so that future appreciation goes to the next generation free from estate and gift taxes.  Examples include Family Limited Partnerships (FLP), Qualified Personal Residence Trusts (QPRT), Grantor Retained Annuity Trusts (GRAT), and sales to grantor trusts (also known as sales to Intentionally Defective Irrevocable Trusts (IDIT)).  Of course, a key assumption is that the real estate and stock markets are going to rebound, but if they do, the estate and gift tax savings can be substantial.

2. Income Tax Rates are Probably Going Up.  In light of the upcoming change of power in Washington, it appears likely that the days of a 15% long-term capital gains rate may soon be gone.  If you have investment assets with previously unrecognized gains and if you have to recognize gains now, it may make sense to do so while tax rates remain at their current levels.  Although many strategies do not require recognition of tax gains, if implementation of your wealth transfer plan requires you to recognize gains, today's income tax rates will be significantly lower.

3. Interest Rates Continue to Fall.  In order to spur growth while inflation remains in check, interest rates have fallen dramatically.  Some complex estate planning strategies are maximized when the "Applicable Federal Rate" (AFR) is low.  The AFR is the minimum interest rate that can be charged under the federal tax code without having "imputed income" on "below market" loans (i.e., the lender is taxed on interest he should have received even though the lender didn't actually charge interest).  The February AFR used in many wealth transfer strategies is down to a ridiculously low 1.65%.

4. Annual Exclusion Gifting.  As of January 1, the "annual exclusion amount" for tax-free gifts increased from $12,000 per recipient per year to $13,000 per recipient per year. The "annual exclusion amount" is the maximum gift that can be made to an individual recipient during any year without paying gift taxes or even reporting the gift, and there is no limit on the number of recipients of the gifts. If you are married, your spouse can join in making gifts, and the two of you may transfer up to $26,000 per recipient per year tax free. Combining this strategy with today's depressed valuations makes annual exclusion gifting of investment assets a potentially powerful strategy.

In addition, it's always a good idea to review your estate plan regularly just to make sure that everything is up-to-date and reflects your current needs and goals.  A lot can happen over time, both in the nature of your investment portfolio and your personal situation, and these changes may warrant a modification to your plan.  This year, there's even more reason for vigilance because the IRS's new deferred compensation laws under Section 409A take effect on January 1, 2009, and certain payment arrangements, including some nonqualified retirement plans, severance plans, and other deferred compensation programs, may be affected.

Now is a great time to sit down to review where you are and where you want to go.  Taking advantage of the current economic climate could pay huge dividends to you and your family in the future.

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Family Limited Partnerships are Still Viable

By Tom Sigmund

 The family limited partnership (FLP) or family limited liability company is a popular method for shifting wealth from one generation to another.  However, because of its misuse, the IRS has attacked the planning, sometimes with successful results.

The family limited partnership is quite simply an association of two or more persons to carry on as co-owners, a business for profit.  Typically, with an FLP, parents or grandparents create the partnership and transfer personally owned assets into the same.  Typically the FLP is funded with real estate, stock in a family owned corporation, publically traded securities, or a combination of these assets. 

When limited partnership interests are gifted to the founder's children or other individuals, there is legal support to justify discounting the value of the partnership interests.  With appropriate discounts taken for lack of control and lack of marketability, the value of the limited partnership interest that is gifted is not equal to the value of the underlying assets.  Taxpayers have been very successful in justifying and supporting these discounts in the context of gifting.  For the most part, the IRS attacks relating to the gifting discounts have boiled down to an argument over the amount of the discounts.  Put differently, if these cases end up in tax court, it often boils down to a battle between the IRS's valuator and the taxpayer's valuator.

When grandparents or parents die owning partnership interests, it is not inappropriate to discount the value of these interests in the same manner discussed above if they die owning a non-controlling interest in the partnership.  More accurately, if the decedent dies without the right to cause the liquidation of the partnership, discounts may be appropriate.

Utilizing principles found in the Internal Revenue Code, the IRS has been successful numerous times in attacking the appropriateness of discounts taken on the partnership interests owned by a decedent by establishing that the decedent either (1) died  with possession or enjoyment of, or the right to the income from the assets transferred into the partnership or (2) died with possession of the right, either alone or in conjunction with another person, to designate the persons who shall possess or enjoy the property or the income therefrom.  This approach by the Internal Revenue Service has caused some practitioners to declare the demise of this planning.  However, upon closer analysis, a good argument can be made that the IRS has been successful in these cases because of the bad facts associated with the same.  In the proper circumstances, a properly formed and properly operated partnership can still prove to justify valuation discounts on the interests owned by the founder at the founder's death.  Some of the more important elements of this planning are the following:

1. Decedent's control over distributions out of the partnership or liquidation of the partnership.
2. Contributions to the partnership by other family members.
3. Valid non-tax purposes for the formation of the partnership.
4. Pro-rata distributions, if any, from the partnership.
5. Avoidance of death bed situations.
6. Avoid the transfer of personal assets into the partnership.
7. Retaining enough assets for the decedent to support the decedent for the remainder of the decedent's life after formation of the partnership.
8. Active management by family.

With these considerations and other considerations in mind, the IRS may very well accept the principles associated with discounts for lack of control and lack of marketability, notwithstanding its distaste for this planning.

Very recently, a family limited partnership was formed for one of our clients.  Our client was in her 90s.  Approximately 60% of the decedent's estate was transferred into a family limited partnership.  The assets transferred were marketable securities.  A corporation was named as a general partner of the partnership and owned a 1% interest in the partnership.  Our client owned a one-third interest in the corporation with her daughter and son-in-law each owning a one-third interest in the same.  Our client's daughter and son-in-law each contributed a small amount of money to the partnership as well.

Unfortunately, approximately six months after the partnership was formed, our dear client passed away.  This was an unexpected death, notwithstanding our client's age.  She was in great health when we formed and funded the partnership.  She was able to execute all of the documents and discuss all of the issues surrounding this planning.  She died owning in the aggregate approximately 98.75% of the partnership.  However, she could not unilaterally cause the liquidation of the partnership.

Prior to our client's death, our client's daughter and son-in-law caused the partnership to purchase rental real estate.  Thus, the partnership, which was once the owner of only marketable securities, now had other assets.  The partnership entered into a contract for the aforesaid real estate prior to our client's death.  However, the closing occurred subsequent to our client's death.

In preparation of the estate tax return, we hired an accounting firm to value the partnership interests owned by our client at her death.  The valuation firm applied discounts for lack of control and lack of marketability of 10% and 25%, respectively.  This resulted in a substantial reduction in the value of the partnership interests as compared to the underlying assets owned by the partnership.

As expected, the Internal Revenue Service audited our client's estate and focused heavily on the partnership.  In light of our client's premature death, it was only reasonable to assume that the Internal Revenue Service would fight hard to negate the discounts and cause the full value of the property to be includable in our client's estate for estate tax purposes.  However, the IRS accepted the 10% minority interest discount and accepted a 21% lack of marketability discount.

The success of this audit can be attributable to the fact that the partnership was properly formed and operated.  Personal assets were not transferred into the partnership.  Our client owned assets outside of the partnership adequate to support her for the rest of her life.  This support included any estate taxes associated with our client's death.  Further, actions were being taken prior to our client's death to restructure the investments of the partnership.  The Internal Revenue Service put no weight on the fact that death occurred shortly after the formation of the partnership and effectively upheld the existence of the partnership and its effect on valuation.

If done properly, family limited partnerships and family limited liability companies can still prove to be viable plans to assist our clients with estate and gift tax savings.  We must go into this planning with a complete understanding of the law that surrounds the same.  In addition to serving the tax purposes discussed herein, these entities are also effective for succession planning, for promoting and implementing family investment activities, and for creditor protection.

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