1. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Corporations, Partnerships, Estates & Trusts 1 Chapter 19 Family Tax Planning

2. The Big Picture Martin, age 75, is a wealthy widower who is considering making a lifetime gift of $500,000 to his only daughter, Francine. Among the assets that Martin can choose from, each worth $500,000, are the following. –Farmland (current use value of $100,000). –Partial interest in a closely held partnership. –Insurance policy on Martin’s life with a maturity value of $3 million. –Marketable securities (adjusted basis to Martin of $900,000). –Unimproved residential city lot (adjusted basis to Martin of $100,000). –Ten annual installment notes from the sale of land (basis of $200,000) with a maturity value of $700,000. In terms of present and future tax consequences, evaluate each choice. Read the chapter and formulate your response.

3. Family Tax Planning Involves the use of various techniques that minimize tax on transfers within the family –Must consider transfer taxes and income taxes –Valuation of transferred property is important Gift tax is based on FMV on date of transfer Estate tax is based on FMV on date of death or alternate valuation date (if elected)

4. Valuation Concepts (slide 1 of 4) Fair Market Value –“Price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts”

5. Valuation Concepts (slide 2 of 4) Stocks and bonds –If sold on a stock exchange, the average of the highest and lowest selling price on the valuation date is FMV –If no sales occur on the valuation date FMV is the weighted average of the means of the highest and lowest sales prices on the nearest date before and after the valuation date –Average is weighted inversely by the respective number of trading days between selling dates and valuation date

6. Valuation Concepts (slide 3 of 4) Notes receivable –FMV = unpaid principal + accrued interest –May also consider low interest rate, distant maturity date, and financial condition of the borrower Insurance policies and annuity contracts –FMV=cost of comparable contract –Valuation of noncommercial annuity contracts requires the use of special tables issued by the IRS

7. Valuation Concepts (slide 4 of 4) IRS tables are used to value –(1) assets which will be held for a period of years –(2) assets owned over a life expectancy or –(3) a remainder interest on expiration of (1) or (2) The value of (1) or (2) is the present value of the income stream allocable to the party receiving the benefits during that period An ownership interest “for life” is based on an assumed life expectancy per mortality tables prepared by the IRS

8. Real Estate and Special Use Valuation (slide 1 of 4) Real estate is usually valued at its most suitable (best or highest) use –An election is available to value certain real estate used in farming or in a closely held business at its “current” use

9. Real Estate and Special Use Valuation (slide 2 of 4) Special use valuation provides relief against having to sell part of the family farm to pay estate taxes Permits a reduction of no more than $1,020,000 in estate tax valuation in 2011 (indexed annually)

10. Real Estate and Special Use Valuation (slide 3 of 4) To qualify for election, must meet all of the following requirements: –At least 50% of value of gross estate consists of real or personal property used in farming or in a closely held business –Real property used in farm or business must comprise at least 25% of gross estate

11. Real Estate and Special Use Valuation (slide 4 of 4) To qualify for election, must meet all of the following requirements: (cont’d) –Property passes to qualifying heir (certain family members) –Real property owned and used in farm or business for 5 of last 8 years –Decedent or family member materially participated in farm or business in the 5 year period specified above

12. Valuing a Closely Held Business (slide 1 of 4) Valuation of closely held businesses should include consideration of the following: –The nature of the business –The economic outlook of the specific industry –The book value of the stock and financial condition of the business –The earning and dividend-paying capacity of the company –Whether the enterprise has goodwill or other intangible value –The prices and number of shares of the stock sold previously and the size of the block of stock to be valued –The market price of stocks issued by corporations in the same or a similar line of business

13. Valuing a Closely Held Business (slide 2 of 4) Goodwill –If a closely held corporation’s past earnings is higher than usual for the industry, the IRS may claim that goodwill is present –The estate may counter this claim by arguing that The average net profit for past years is not representative The appropriate rate of return for this type of business may be higher (reducing goodwill) The deceased was a key person in the company and so the goodwill might be seriously impaired by that party’s death Others

14. Valuing a Closely Held Business (slide 3 of 4) For publicly traded entities, a “blockage” discount factor may be used –This represents the reduction in market value which would occur if the entire ownership interest was sold on the same date –e.g., If 20% of the stock in a corporation was offered for sale at the same time, the value of all the stock would decrease

15. Valuing a Closely Held Business (slide 4 of 4) Buy-sell agreements allow the value of an interest in a closely-held business to be fixed –The agreement states the price paid to buy out the other owner’s interest upon his death Life insurance is frequently acquired to cover costs of purchase –The price must be “reasonable” or the IRS may disregard it –Discounts for minority ownership or control premiums may be assigned to a stock or partnership interest

16. Cross Purchase Buy Sell Agreements (slide 1 of 2)

17. Cross Purchase Buy Sell Agreements (slide 2 of 2) Financial result: Each owner has a larger percentage ownership (e.g., ownership goes from 33 1/3% to 50% if one dies) –Advantage of Cross Purchase Arrangement: Each owner has an increased basis in the asset owned –Disadvantage: With several owners, the number of insurance policies needed to fund all possible death events is very large and expensive

18. Entity-Purchase (Redemption) Buy-Sell Agreement (slide 1 of 2)

19. Entity-Purchase (Redemption) Buy-Sell Agreement (slide 2 of 2) Financial result: Each owner again has a larger percentage ownership (e.g., ownership goes from 33 1/3% to 50% if one dies) –Advantage of Redemption Agreement: Simple to complete if there are many owners, may be less costly if only a few insurance policies are needed –Disadvantage: Since entity assets are used to purchase deceased owner’s interest, the remaining owners’ bases in the stock or partnership interests are not adjusted

20. Income Tax Concepts (slide 1 of 2) Basis of gifted property (gifted after 1976) depends on whether property is sold for a gain or loss –Donee’s basis for gain is donor’s basis plus gift tax attributable to appreciation to the date of gift –Donee’s basis for loss is lesser of: Basis for gain, or FMV on date of gift

21. Income Tax Concepts (slide 2 of 2) Basis of property acquired by death –FMV on date of death or AVD, if elected –If property has appreciated, heir gets a step-up in basis Heir may be required to assume decedent’s basis if: –Decedent received appreciated property as a gift within one year prior to death, and –The property is acquired from the decedent by the donor

22. The Big Picture – Example 19 Basis Of Property Acquired By Death Return to the facts of The Big Picture on p. 19-2. Suppose that Martin is considering only the city lot and the marketable securities. A gift of either would make $500,000 subject to the Federal gift tax, and this would become Francine’s income tax basis under § 1015. If instead these assets pass to Francine by Martin’s death, under § 1014 she would receive: –A step-up in basis in the city lot (i.e., from $100,000 to $500,000). –A step-down in basis in the marketable securities (from $900,000 to $500,000). Hence, Martin should sell the securities while he is alive, so as to benefit from the $400,000 built-in loss.

23. Estate and Gift Planning (slide 1 of 13) Use annual exclusion and gift splitting election to reduce or eliminate gift taxes and reduce potential estate taxes –e.g., Mom and Dad have 4 children and 8 grandchildren and a combined potential gross estate of $10,000,000 Through an annual gifting program, they can remove $312,000 per year (12 donees × $26,000) from their combined estate Potential estate tax savings at 35% = $109,200 per year (for 2011)

24. Estate and Gift Planning (slide 2 of 13) Current gifts can reduce later estate taxes –e.g., Dad owns real estate which is expected to increase in value by 8-12% per year, and he owns stock in a closely held business which he believes will increase 20-25% per year –With a regular gifting program, he can reduce his eventual estate taxes: growth in the estate will be minimized

25. The Big Picture – Example 27 Minimizing Estate Taxes Return to the facts of The Big Picture on p. 19-2. One of the assets Martin is considering giving to Francine is an insurance policy on his life. Although the policy has a current value of only $500,000, it has a maturity value of $3 million. Therefore by making a gift of $500,000, Martin would save a future inclusion in his gross estate of $3 million.

26. Estate and Gift Planning (slide 3 of 13) Downside: donee has carryover gift basis (instead of “stepped up” estate basis) Goal: eventual tax at capital gains rates is less than the estate tax on increased basis –Plus, if asset held beyond Dad’s death, donee has time value of tax savings

27. Estate and Gift Planning (slide 4 of 13) Gifts can save income taxes for the family unit –Note: “Kiddie” tax, imputed interest rules, family partnership rules, and certain other rules have significantly reduced the effectiveness of this technique –e.g., Mom and Dad transfer $26,000 each to their 19- and 20-year old children who attend college. The money is invested in a stock fund averaging 8% per year earnings. The earnings are used to pay living expenses while at college.

28. Estate and Gift Planning (slide 5 of 13) Assume kids pay tax of 10% vs. parents 35% tax: savings on $4,160 income = $1,040 per year –Downside: parents have turned over $52,000 of assets, which parents may need for retirement or other purposes –Positive side: children should have adequate funds for college, etc...

29. Estate and Gift Planning (slide 6 of 13) Appropriate gifts can help an estate qualify for: –“Special use valuation” –Use of “flower bond” provision (ability to receive redemption treatment for repurchase of stock to pay estate taxes)

30. Estate and Gift Planning (slide 7 of 13) Most of these tax savings provisions require real estate in the estate or the value of the business interest in the estate to exceed a specified percent of the gross estate The strategy, then, is to remove non-qualified assets from the estate (e.g., personal residence or personal effects), and allow the business assets to be a higher percent of estate value

31. The Big Picture – Example 31 Special Use Valuation Property Return to the facts of The Big Picture on p. 19-2. Making a gift of the farmland is probably unwise for two reasons. –First, without further information on the other assets Martin owns, it is impossible to ascertain how close he might be to meeting the percentage requirements of § 2032A. –Second, even if the special use valuation election is not available, consider the substantial step-up in basis that occurs (i.e., $100,000 to $500,000) if the farmland is passed at death.

32. Estate and Gift Planning (slide 8 of 13) To be effective, gifts of these assets must generally be completed three years prior to death Avoid gifts of property which could have income tax consequences to the donor (e.g., gifts of encumbered property)

33. The Big Picture – Example 34 Income Tax Consequences To The Donor Return to the facts of The Big Picture on p. 19-2. Recall that another asset that Martin is considering giving Francine is installment notes receivable. Although the notes have a face amount of $700,000, due to the extended payout period and possibly other factors (e.g., a low interest rate), their current value is only $500,000. Unfortunately, Martin’s basis in the notes is $200,000. Thus, since the gift is treated as a sale, Martin would have a taxable gain of $300,000 ($500,000 - $200,000).

34. The Big Picture – Example 35 Carryover Basis Situations Return to the facts of The Big Picture on p. 19-2. Assume that Martin is terminally ill and cannot take advantage of any more capital losses. –e.g., he has excess capital loss carryovers from prior years. Is it preferable for Martin to give the marketable securities to Francine or for them to pass to her at his death? Under a gift scenario, she takes the securities with a basis for gain of $900,000 and a basis for loss of $500,000. Under a death scenario, however, Francine’s basis for both gain and loss steps down to $500,000.

35. Estate and Gift Planning (slide 9 of 13) Minimize probate costs by: –Holding property as joint tenants with right of survivorship, or –Designating a beneficiary for checking and savings accounts, retirement accounts and life insurance policies Assets held or transferred in this manner are not included in the probate estate Reduces legal costs of probate, which are frequently based on a percent of assets transferred, even if the transfer process is not time consuming or difficult.

36. Estate and Gift Planning (slide 10 of 13) Removing assets from the probate estate does not generally decrease estate taxes Make lifetime charitable contributions –This provides a current income tax deduction, and the funds are not included in the gross estate –Transfers at death only reduce estate (not income) taxes

37. Estate and Gift Planning (slide 11 of 13) Make use of the “bypass” or unified credit amount –Make sure each spouse allocates the current unified credit amount of assets which will not again be included in the surviving spouse’s estate

38. Estate and Gift Planning (slide 12 of 13) If other funds are not adequate to provide for the surviving spouse, a “special power of appointment” can be added which will let surviving spouse use trust money for “health, education, support or maintenance”

39. Estate and Gift Planning (slide 13 of 13) Disclaimers can be used to control the amount of the marital deduction and ensure the full “bypass” amount is used –e.g., Surviving spouse can refuse to accept the current unified transfer credit equivalent amount of assets. The disclaimed amount is transferred under the decedent’s will or by state law (generally to children) –Disclaimers are used if decedent did not have a will, or the will did not reflect appropriate estate planning

40. Marital Deduction Planning (slide 1 of 2) A deduction is available for all amounts passed through an estate to a surviving spouse and for gifts to a spouse –This is the “Marital Deduction” There is no limit on the amount of this deduction Two approaches are commonly used to optimize estate and gift taxes using the marital deduction

41. Marital Deduction Planning (slide 2 of 2) Equalization –Gifts are made between spouses to equalize the estate of the spouses to take advantage of: (1) Each spouse’s unified credit and (2) Graduated tax rate schedules Deferral –Maximize marital deduction for first-to-die (no estate taxes paid) Second spouse uses lifetime gifting program

42. Estate Tax Planning Example (slide 1 of 2) William (age 56) has $5,200,000 in assets His wife, Sarah (46) has $1,000,000 in assets Neither has used any of the unified credit They have three children, ages 26, 21 and 20 They will turn the business over to the children when William is 65

43. Estate Tax Planning (slide 2 of 2) Assets (and projected annual growth) include the following: William Sarah. Personal effects (2%)$ 100,000 $ 100,000 Investment accounts (6%) 400,000 500,000 Real estate (15%) 600,000 300,000 Retirement accounts (8%) 500,000 100,000 100% of closely held Corp (25%) 3,600,000 -0- Totals$5,200,000 $1,000,000 Discuss estate planning strategies for William and Sarah.

44. Estate Plan Example Proposed Strategy (slide 1 of 14) Both parties are relatively young, so their estate plan should minimize estate taxes, while providing funds for a long retirement life expectancy Both potential “first to die” scenarios should be considered

45. Estate Tax Example Proposed Strategy (slide 2 of 14) 1.The “deferral” approach should probably be used for William’s marital deduction –Sarah is younger than William, so, statistically, after William’s death she will have several years in which to make lifetime gifts to reduce her estate tax liability –Therefore, William will leave most of his wealth to Sarah after using his unified credit exemption amount

46. Estate Tax Example Proposed Strategy (slide 3 of 14) 2.Sarah should probably use the “equalization” (or current payment) approach –Sarah’s estate is much lower than William’s. She can use her unified tax credit and pay no tax on her estate –William’s estate is so large, he will already have trouble gifting away enough to go below the 45% bracket, and –He’s older, so she should not compound his situation by leaving additional funds to him

47. Estate Tax Example Proposed Strategy (slide 4 of 14) 3.The business is expected to grow at 25% per year, so William’s estate tax liability will escalate unless something is done –Several goals can be accomplished at once if the following approach is followed:

48. Estate Tax Example Proposed Strategy (slide 5 of 14) a. “Freeze” the value of the stock in the business by recapitalizing into preferred and common stock –The preferred stock must be cumulative and must pay a reasonable rate of interest (say 7%) –The common stock must be assigned a value of at least 10% of the total value ($360,000)

49. Estate Tax Example Proposed Strategy (slide 6 of 14) b. Assuming William wants to retain control of the company until retirement, he can keep, say 55% of the common stock and give 15% each to the three children If this is done over three years, gift splitting can be used, and none of his unified credit will be absorbed –Instead of 25% annual growth, he will have 7% growth on $3.24 million preferred, and 25% on the low value common

50. Estate Tax Example Proposed Strategy (slide 7 of 14) c. William can also hire the children –This should stimulate their interest in the business and train them to take over in the future –Also, if their salaries are fairly high, this removes assets from the company which would otherwise be reflected in an increase in value of William’s (and the children’s) common stock

51. Estate Tax Example Proposed Strategy (slide 8 of 14) 4. Annual gifting should be used –The common stock should be gifted as described above –Also, the real estate is a good candidate since it is expected to appreciate 15% per year

52. Estate Tax Example Proposed Strategy (slide 9 of 14) Real estate is difficult and expensive to transfer in small units –May want to sell it to the children on an installment basis (e.g., for no cash), with up to $26,000 (using gift-splitting election) of the debt forgiven each year –Imputed interest must be considered on the debt IRS may treat the gift as occurring in the first year if the forgiveness requirement is binding

53. Estate Tax Example Proposed Strategy (slide 10 of 14) They may wish to also gift enough of their assets (e.g., real estate or stock in the company) to use the unified credit currently This moves future appreciation or future stock dividends to the children’s estate at no current tax cost

54. Estate Tax Example Proposed Strategy (slide 11 of 14) Gifts of preferred stock also transfer future income to the children who are likely in lower current tax brackets –None of the children are subject to the “kiddie tax” rules

55. Estate Tax Example Proposed Strategy (slide 12 of 14) 5.In the gifting program, pay attention to the percent of the estate represented by company stock –If the estate qualifies, some of the corporate stock can be redeemed by the company (at capital gains rates) to pay estate taxes

56. Estate Tax Example Proposed Strategy (slide 13 of 14) 6.After William retires, he can continue to gift common stock. –Reduces his estate value –Once he no longer “controls” (> 50%) the company, estate can claim a valuation discount 7.If the unified credit is not used for gifts currently, both William and Sarah should set up bypass trusts in their wills. –This utilizes the unified credit and can give the spouse lifetime access to the funds in the trust

57. Estate Tax Example Proposed Strategy (slide 14 of 14) 8.Make sure beneficiaries are named for checking accounts, investments (if possible) and retirement accounts –This reduces probate costs

58. Refocus On The Big Picture (slide 1 of 3) Is Martin’s potential estate a possible candidate for a § 2032A election (i.e., special use valuation method)? –If so, a gift of the farmland could make it hard to meet the percentage qualification requirements of § 2032A. –Qualifying under § 2032A would allow the farmland to be valued at $100,000 (rather than $500,000) for estate tax purposes (see Example 31). Is it possible that Martin’s potential estate would use the deferred payment procedure of § 6166? –If so, the gift of the partnership interest could impair the closely held business qualification requirement for the § 6166 election.

59. Refocus On The Big Picture (slide 2 of 3) The gift of the life insurance policy is very attractive. –By making a gift of $500,000, Martin avoids $3 million being subject to the estate tax (see Example 27). –This assumes that Martin’s estate avoids the three-year trap of § 2035. The marketable securities might better be sold to enable Martin to recognize an income tax loss of $400,000. –However, a gift could preserve some of the built-in loss for the donee (see Example 35). –Otherwise, there will be a step-down in income tax basis if Martin dies with these securities.

60. Refocus On The Big Picture (slide 3 of 3) The gift of the city lot shifts to the donee a built-in gain of $400,000. –If this property passes by death, it receives a step-up in basis (see Example 19), and the gain component disappears. In either case (i.e., gift or inheritance), the amount subject to a transfer tax is $500,000. The installment notes receivable present a ‘‘no win’’ situation. –If Martin transfers them by gift, he must recognize income on the transfer (see Example 34). –If, they pass by death, however, either the estate or the heirs will have to recognize the deferred gain. –As the gain is income in respect of a decedent, there is no step-up in basis due to Martin’s death.

61. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 61 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta