Dedon on Estate Planning

Asset Protection For Business Owners

See the attached article below published on December 2, 2009 in Virginia Business Magazine on asset protection for business owners.

Wednesday, December 2, 2009

Virginia Business

Asset protection for business owners in uncertain times

December 02, 2009 11:30 AM
John Dedon

 

Many business owners face a number of issues unrelated to revenue and expenses. One pressing concern is the threat to the business from liability claims. If you are selling a product or providing a service, the danger that you may be the target of a products liability or negligence claim is a reality of doing business. The business could be selling automobiles, landscaping, real estate development or property management, customers in a store. It does not matter because the concern is the same: if I am sued am I personally at risk, and is my business at risk?

Checklist of protection steps

Here is a checklist of basic safeguards all business owners should have in mind:

1. Do you have sufficient liability insurance in amount and in scope of coverage?

2. Are you aware of the various statutes of limitations that may protect you from various claims?

3. Do you operate as a corporation or LLC so that you are protected personally?  Thus, liability would be limited to the entity, not its shareholders, officers or directors.  This assumes you observe the corporate formalities so that a plaintiff could not “pierce the corporate veil.“

4. If the corporate veil was pierced, perhaps the stock is owned in a Trust or separate entity so that you are not personally liable as the shareholder.

5. If you operate as an S corporation or an LLC, do you pay out most or all of the earnings to the owners so that, if liability is limited to the entity, there are not significant assets at risk?

6. If there are various business activities (e.g., real estate holdings, real estate management, and real estate sales) do you maintain LLC’s or Corporation’s for each business to segregate liability?

7. If somehow personal liability attaches to the owners, officers, or directors, have you titled and positioned your personal assets so that the personal assets are protected? These personal steps could include tenants by the entirety, trusts, or entities that receive the protection of charging orders.  For more information on these personal steps, see below.

Personal liability protection

If you are a professional you may be subject to personal liability for negligence claims regardless of the entity you create.  Alternatively, any business owner who fails to take the necessary steps to ensure the corporation or LLC entity is respected can be liable if the plaintiff or creditor “pierces the corporate veil.”  In either of these events, you may be personally liable.  In the case of personal liability, what steps can you take to protect yourself short of a bankruptcy filing?

Here are some fundamental planning considerations:

1) Assuming you are married, are your assets titled “tenants by the entirety” with your spouse?  Many states, such as Virginia, protect assets from claims against only one spouse if the assets are jointly titled with the spouse.  One negative of titling assets “tenants by the entirety” is that it may not be desirable for estate planning purposes.

2) Have you irrevocably transferred assets to trusts with an independent trustee for beneficiaries, such as your children?  In this event, if a claim later arose after the transfer the assets in trust would be protected.  Some states, such as Delaware, offer additional asset protection if a Delaware irrevocable trust is created and managed by a Delaware Trustee.

3) Are you using LLCs or family limited partnerships with several members or partners so that, if you are sued, the remedy is a “charging order. “ A charging order precludes the creditor from attaching the assets or your ownership interest. 

Of course, if you transfer assets after a claim or judgment arises, none of these transfers would be protected if the plaintiff can prove a “fraudulent conveyance.”  A fraudulent conveyance refers to a transfer that renders you insolvent or that is done with the intent to delay, defraud or hinder creditors.  Therefore, the protective planning described above is best accomplished and mostly likely to succeed if done before any known or potential claims exist.  If the planning is part of a comprehensive estate plan it further enhances the likelihood of success.

John P. Dedon is a principal in the firm with the Trust, Estate & Tax Planning practice group of Odin, Feldman & Pittleman. Dedon blogs about estate planning issues for Virginians and U.S. citizens at dedonestateplanning.typepad.com

Protecting Business Owners From Creditors

Many business owners face a number of issues unrelated to revenue and expenses. One pressing concern for many business owners is the threat to the business from liability claims. If you are selling a product or providing a service, the danger that you may be the target of a products liability or negligence claim is a reality of doing business. The business could be selling automobiles, landscaping, real estate development or property management, customers in a store - it does not matter because the concern is the same: if I am sued am I personally at risk, and is my business at risk?

Here is a checklist of basic safeguards all business owners should have in mind:

1. Do you have sufficient liability insurance in amount and in scope of coverage?
2. Are you aware of the various statute of limitations that may protect you from various claims?
3. Do you operate as a corporation or LLC so that you are protected personally?  Thus, liability would be limited to the entity, not its shareholders, officers or directors.  This assumes you observe the corporate formalities so that a plaintiff could not "pierce the corporate veil."
4. If the corporate veil was pierced, perhaps the stock is owned in a Trust or separate entity so that you are not personally liable as the shareholder.
5. If you operate as an S corporation or an LLC, do you pay out most or all of the earnings to the owners so that, if liability is limited to the entity, there are not significant assets at risk?
6. If there are various business activities (e.g., real estate holdings, real estate management, real estate sales) do you maintain LLC's or Corporation's for each business to segregate liability?
7. If somehow personal liability attaches to the owners, officers or directors, have you titled and positioned your personal assets so that the personal assets are protected? These personal steps could include tenants by the entirety, trusts, or entities that receive the protection of charging orders.

Each topic in this list could lead to a discussion in and of itself, but this is a good starting point.

Life Insurance

Many clients rely on life insurance as part of their estate plan.  Indeed, for clients with taxable estates, it is difficult to plan without using life insurance to pay estate taxes.  Life insurance is particularly important if the assets are illiquid, such as real estate or a closely held business, and the estate tax needs to be paid within nine months of death.

Life insurance can be purchased so that the entire amount of the death benefit is received by the beneficiaries estate tax free. For example, under current law, if a husband and wife have assets worth $7 million exclusive of life insurance, and they have a $3 million life insurance policy in an irrevocable trust, the children receive $10 million estate tax free.  This assumes the assets are positioned properly to take advantage of each spouse's $3.5 million exemption and the irrevocable trust is the original owner of the policy.

When creating an irrevocable trust, several complicated issues arise that are the Trustee's responsibility.  If the Trustee is a family member unfamiliar with the legalities of irrevocable trusts, professional guidance is necessary.  Issues relevant to the Trustee include (1) is a Trust account opened by the Trustee to receive premium payments; (2) assuming the grantor pays the premium, is the payment protected by the annual exclusion; (3) the answer to (2) above often depends on whether "Crummey letters" have been prepared, qualifying the premium payment for the annual exclusion.

The Trustee also is responsible for making sure the policy is performing properly, e.g., are the policy assumptions pertaining to interest and mortality rates appropriate?  Also, the Trustee must determine if the insurance carrier is still a strong company.

Using an Irrevocable Trust to own life insurance provides significant advantages.  However, the advantages come with some complication; namely, choosing the right Trustee.  If the Trustee is not an institution or professional, the Trustee must know where to turn for help in dealing with a myriad of issues.

Estate Tax Legislation

Inquiring minds want to know:  what is the latest in Congress on estate tax? All tax legislation must come from the House Ways and Means Committee, and two news items came out of Ways and Means last week.

First, Chairman Charles Rangel, despite his own problems and contrary to earlier statements, said he is drafting a bill to make the $3.5 million exemption permanent. In the past, Rangel said he favored extending the $3.5 exemption amount one year and addressing it again in 2010.

Second, two other Ways and Means Committee members introduced legislation to increase the exemption to $5 million over the next 10 years, plus index the amount for inflation. This bill would also lower the estate tax rate from 45% to 35%.

As you know from reading this Blog and other publications, if the estate tax law is not addressed the exemption amount will fall to $1 million with a maximum 55% tax rate in 2011. The estate tax would disappear entirely for one year, 2010. Hence, the estate tax system is a Congressional priority, notwithstanding all the other issues Congress is now facing.

Besides dealing with the exemption amount and the tax rate, there are other important estate issues before Congress. For example:

• the issue of "portability," i.e., the ability of a married couple to protect $7 million without having to carefully arrange asset titling and beneficiary designations prior to their deaths.

• whether Congress should curtail certain advanced estate planning tools, such as being able to discount for tax purposes the value of intra-family gifts and the use of 2-year GRATS.

(I have written in prior posts on portability, discounting and GRATS.) As of now, it is anticipated that none of these subjects will be addressed this year.

Settling Tax Issues with the IRS

The IRS is gearing up its tax compliance efforts after a few years of reduced activity. One indication of these increased efforts is the recent hiring of 400 new IRS Appeals Division employees. The IRS now has roughly the same number of Appeals Officers that existed a decade ago. As professionals who deal with the IRS know, the Appeals Division is the second layer of IRS review for taxpayers whose estate and income tax returns are audited.

The first level is the audit level, where the agent is likely to view issues from the IRS perspective. If matters cannot be settled at the audit level, the next step is typically the Appeals Division. The Appeals Officer is supposed to consider the "hazards of litigation," meaning rather than take a biased IRS view, the Appeals Officer should consider the legal issues supporting each side and strive to reach a reasonable settlement. As Kurt Meier, deputy chief of the Internal Revenue Service's Appeals division recently said at an American Bar Association luncheon, Appeals must provide an "impartial, fresh look." It has been my experience that most Appeals Officers subscribe to this view.

Therefore, often taxpayers who settle their tax problems with the IRS will do so at the Appeal level, not at the audit level with an agent. Settling at the Appeals level avoids the added cost and time involved in Tax Court litigation. For this reason, having adequate Appeals Officers on board is not bad news.

Charitable Contribution Deductions

Many donors are confused whether they can claim a charitable income tax deduction for gifts directly to individuals. Even if the donee is poor and in need, a contribution directly to that individual does not necessarily result in a charitable contribution deduction.

Some background: Generally only contributions to charities are tax deductible. The IRS determines whether an organization is a qualified charity. Charitable organizations are generally two kinds: (1) public charities, such as universities, churches, relief organizations such as the Red Cross and the United Way, and most hospitals, or (2) private foundations. While public charities receive much of their support from many donors, private foundations are typically created by individuals and receive support from a limited number of people, such as from one family. So if Mom and Dad create a charity and they are the sole contributors that charity will be private foundation.

Although contributions to both public charities and private foundations are tax deductible, public charities enjoy more advantages. For example, a private foundation must distribute 5% of its assets annually. If 5% of its assets are not distributed, then taxes are imposed.

So back to my earlier point: if Mom and Dad create their own private foundation and it is approved by the IRS, that foundation cannot make distributions directly to individuals unless the foundation receives IRS approval for such specific grants. Thus, it is not sufficient to receive IRS approval for the foundation; the IRS also must bless the contributions directly to the donee-individuals. Mom and Dad must tell the IRS they intend to offer scholarships or grants directly to individuals. Mom and Dad must tell the IRS the criteria for selection, the potential grantees, who will do the selection, and other information. The IRS wants to make sure the donees are not, for example, Mom and Dad’s family. On the other hand, if Mom and Dad’s IRS approved private foundation distributes directly to a public charity, no prior IRS approval is required for the distribution.

In sum, when you donate to your church or your university and don’t receive anything in return, you obtain a charitable contribution deduction. However, if you create your own charity you need to obtain IRS approval as a private foundation and additional IRS approval if your private foundation intends to give directly to individuals. No contribution deduction is allowed for contributions directly to individuals that do not flow through qualified charities.

Estate Tax Legislation?

Is this the week Congress establishes certainty in the estate tax law? Probably not but talks are ongoing.

According to House Ways and Means Committee Chairman Charles Rangel, Committee members this week are continuing to discuss how to avoid the one-year elimination of the estate tax. Under current law, there would be no estate tax in 2010 but in 2011 the estate tax would return and cover estates exceeding $1 million at maximum tax rates of 55%. Currently, there is a $3.5 million exemption amount. For married taxpayers who do the proper planning, they can double the exemption amounts ($2 million in 2011 and $7 million in 2009).

It is difficult to plan not knowing whether the estate tax exemption will be extended at the $3.5 million level; whether it goes away temporarily or permanently; whether the exemption is reduced to $1 million; or an entirely unknown alternative. Rangel was quoted last week by the Publisher, BNA, that he favors a one-year extension of the $3.5 million amount rather than a "permanent" solution. President Obama has said he believes $3.5 million is the appropriate amount. On the other hand, Republicans still believe that a greater exemption amount and a lower estate tax rate is appropriate.

My prediction is that Congress will, as Rangel said, extend the $3.5 million exemption for one year, meaning we will have the same uncertainty for at least one more year. The problem would then again have to be addressed 2010. We will know soon. 

GIFT TAX RULES

When it comes to transferring assets for gift and estate tax purposes, there is much confusion regarding the federal rules. What is an annual exclusion gift? How much can I protect from estate tax when I die? Can I give it away before I die? There are many more questions. Let’s consider these rules: (I am assuming U.S. citizens because the rules may be different for non-citizens.)

1. Upon your death, you can protect $3.5 million from estate tax. Although this amount changes on January 1, 2010, virtually everybody knowledgeable in this area expects Congress and the President to extend the $3.5 million amount (or increase it) into 2010 and beyond.

2. Prior to you death, you can give away $1 million without paying any gift tax. However, if you do give away $1 million during your life, the amount of the gift is deducted from what you can protect at your death (unless it is an annual exclusion gift – see 3).

3. In addition to the $1 million, you can give away $13,000 per year to any beneficiary. This "annual exclusion" amount does not have to be to a family member.

4. You can pay education and medical expenses in addition to the $13,000 and the $1 million exemption amount

5. If you are the beneficiary of an inheritance under 1) above, or a gift under 2), 3) or 4) above, you do not pay federal tax on receipt of the gift. If there is a tax consequence, it applies to the person dieing or making the gift.

How do these rules apply? Here are some examples:

Ex 1: Mom and Dad have three children. They can each give $13,000 ($26,000) to each of the three children ($78,000). Mom and Dad can make these same gifts each year without any income or gift tax consequence.

Ex 2: Two of the children are married. There are 4 grandchildren. Mom and Dad also have a favorite niece. They can gift on an annual basis another $182,000 without any income or gift tax consequence (7 x $26,000).

Under Ex 1 and 2, Mom and Dad gave away $260,000, saving $117,000 in estate tax upon their deaths ($260,000 x 45% estate tax).

Ex 3: Mom and Dad are really wealthy and desire to give away more than the annual exclusion amounts in Examples 1 and 2. Thus, they gift $2 million to their three children. Now upon their deaths, they will only be able to protect $5 million between them ($3.5 million each x 2 = $7 million - $2 million gifts).

Ex 4: For all the gifts above, the assets come from Mom’s separate brokerage account. Notwithstanding, Dad can join in the gifts even thought he does not own the assets because of "gift splitting." The "gift split" would be reflected by Mom and Dad filing a gift tax return each year of the gift, which provides information to the IRS but does not cause any gift tax.

Why gift now? There are several answers to this question. For example, asset values are low, thus allowing you to remove more from your taxable estate. Also, all appreciation in the assets will be removed from your taxable estate. Further, there are various gift strategies that allow you to discount the value of the transferred assets for gift tax purposes. IRS interest rates that may apply to some of these strategies are also low now, allowing for more to be removed from the taxable estate.

Obviously there is more to gift and estate tax planning, but these are a few of the basic rules.

Fundamental Estate Planning

This summer may be remembered for the unusually large number of high profile deaths. These deaths cause us to face our own mortality and, for estate planning lawyers, result in more phone calls. It is always surprising how many individuals don't have any planning, such as Wills, Powers of Attorney and Medical Directives. Even fewer people have the appropriate planning, such as Revocable Trusts for probate avoidance or correct beneficiary designations on assets and proper asset titling.

With this in mind, by clicking Download Fundamental Estate Pl Presentation 8-31-09 blog.PPT you can follow a PowerPoint Presentation I will be giving this fall to prospective clients and professionals covering the need for fundamental estate planning, the necessary planning tools to utilize, and the critical importance of examining the ownership of the assets and beneficiary designations. The Case Study in the PowerPoint highlights this latter point.

Family Partnerships and Estate Planning

A recent Tax Court Memorandum Opinion, Estate of Miller v. Commissioner, T.C. Memo 2009-119 (May 27, 2009), adds to the long line of cases involving taxpayers who claim valuation discounts for transfers of assets to family members. The intended result is that, because the asset values are reduced for tax purposes, significant estate tax saving result. As in Estate of Miller, the preferred entity to obtain discounts is often a Family Limited Partnership (FLP). Limited Liability Companies are also often used.

For purposes of highlighting the importance of Estate of Miller, I am eliminating details of the facts. Simply assume the taxpayer transferred marketable securities into an FLP and then gifted limited partnership interests to her children. The gifts occurred over a two year period. The taxpayer claimed a 35% discount from the asset value of the publicly traded securities inside the FLP because the gifts consisted of limited partnership interests. That is, although the marketable securities were in Merrill Lynch and Fidelity accounts, because they had first been transferred into the FLP, and then limited partnership interests were transferred not the public securities, discounts for lack of market and control should apply.

The Tax Court agreed with the taxpayer in concept and allowed discounts for the gifts made in Year One but not Year Two. In broad terms, the importance of the Tax Court’s decision is the following:

Taxpayers can obtain discounts for gifts of limited partnership interests even when the FLP holds marketable securities.

• A 35% discount may be reasonable. Indeed, the IRS did not challenge the amount of the discount. Thus, in theory a discount more or less may be appropriate, depending on the facts.

There must be a business purpose for the creation of the FLP. A "business purpose" means, in essence, a non-tax reason. The Tax Court concluded actively managing marketable securities is a valid "business purpose." Thus, taxpayers do not need to operate a "business" in the sense of a car dealership or government contracting business to rise to the level of a valid business purpose.

So, what did the Tax Court determine was the distinguishing factor between Year One when the gift (and 35% discount) was allowed and the second year when the Court said there was not a legitimate gift? It comes back to business purpose and the non-tax reason for creating the FLP and making the gifts. (The relevant Internal Revenue Code Section is 2036.) The Tax Court stated there was a legitimate non-tax reason to create the FLP. Here, it was primarily the need for an entity to allow a child to continue the active investment philosophy of his parents. The child worked full-time in this activity. Perhaps other factors were important, such as asset protection, succession planning for the family and centralized management. The court also noted the taxpayer had other assets to live on beyond those gifted to her children. Thus, the Year One gift was legitimate.

However, in Year Two when the second round of gifts was disallowed, the taxpayer was not in good health. The Court concluded the gifts were motivated by death bed planning. Also, after this round of gifts, the taxpayer did not have other assets in her own name sufficient to pay her bills. Thus, the Court held the gifts in Year Two were motivated by the taxpayer’s desire to reduce estate tax.

In general, Estate of Miller v. Commissioner is a pro-taxpayer case because it illustrates that FLP’s and LLC’s remain viable gift and estate tax planning tools if set up for valid reasons. However, if thrown together at the last minute as part of death bed planning or without any credible non-tax reason, they will be subject to challenge. The IRS will also challenge the discounts if the formality of the structure is not observed, e.g., commingling assets, failure to make pro rata distributions, opening appropriate accounts, etc.

As I have written about in the past, whether Congress renders these cases moot through legislation that would curb or eliminate discounting in family settings remains an open question.