Today a couple can transfer up to $4 million without having to worry about their estate paying any estate taxes on the death the surviving spouse.  When I have this discussion with my clients, I mention that planning will still continue in order to protect their assets and shift income to heirs.  $4 million is still a lot of money today even in this highly appreciated real estate market.

The first topic deals with the fact that in order to transfer the $4 million to their children they will have to establish the typical family trust that provides for the first $2 million to be transferred into a decedent’s trust.  I recommend that the decedent’s portion of their estate should allow the flexibility to have the surviving spouse to be able to change how the distributions to their children will be if there is a change in circumstances after the death of the first spouse.  Unfortunately, this type of planning is not provided for in some family trust documents that I have reviewed.

What else should you be thinking about, if you have substantial assets that will not be subject to estate tax either because of total repeal of the death tax (good luck) or more than likely your estate may be under the exemption amount? What are the various planning tools to use in this environment?

If wealth preservation is a key motivator for you and protecting them at the same time, using a limited partnership or limited liability company will certainly be one tool.  This is particularly true where real estate is a major asset.  Various types of trusts will also be something to explore.

In a recent article by : JOHN J. SCROGGIN entitled “Income Tax Planning Now That Estate Taxes Are Less Significant” he discusses the various planning tools to think about both now and in the future.

Income tax planning

Many planning opportunities have been limited by concerns over the avoidance of federal estate tax. When estate tax rates reached as high as 60%, while federal income rates topped out at 39.6%, this concern was certainly valid. But these estate tax restrictions will disappear for the vast majority of Americans, whose tax planning strategies will shift from federal estate tax avoidance to state and federal income tax reduction. Here are some of the possible opportunities.

Income shifting. A client who is funding benefits or obligations (e.g., college tuition or support costs) for someone (e.g., a college age child or a parent in a nursing home) who is in a lower income tax bracket should consider adopting approaches by which the ordinary income or capital gains of the client are shifted to the lower tax rate taxpayer. There are a number of methods for accomplishing this task, including the following:

1. Trusts can be created to hold income-producing assets; the trust income is allocated among the beneficiaries based on the trustees’ discretion. These “spray trusts” are discussed in more detail later.

2. The transfer of noncontrolling interests in flow-through entities (e.g., limited liability companies (“LLCs”), partnerships, and S corporations) may be used to shift income to lower-bracket family members without giving up control over the underlying asset or the family business. The recent IRS assaults on family limited partnerships (“FLPs”) have focused primarily on the estate tax aspects of FLPs. However, for most clients, the federal estate tax issues surrounding FLPs will become moot. FLPs remain an excellent tool for maintaining control of an asset, while income earned from the asset is allocated to lower-bracket family members.

3. A business could hire family members to work in the business. However, if the business owner has earned income over $90,000 (in 2005), then this approach could create Social Security taxes which the business owner would not have incurred.

Planning example. Assume a client has a rental property that produces ordinary taxable income of $200,000 per year. The client is in the 35% federal income tax bracket, but his five children and ten adult grandchildren are all in an effective tax bracket of 15%. The client places the rental property in an FLP and retains a 2% general partnership interest. Over two years, he transfers the FLP interests to a spray trust for his descendants using Crummey withdrawal rights to preserve his state and federal estate tax exemptions. The trust has the right to spray income among his descendants. Using the income tax brackets of the 15 trust beneficiaries, the overall federal income tax on his rental property would drop by up to $39,200.

Income shifting can also result in changes in the character of shifted income. For example, suppose that a client is a real estate developer. Because the developer is considered a “dealer” in real estate, income from the developer’s development of real property will generally be treated as ordinary income. If property were initially acquired by, or transferred to, family members who were not developers, sale of the real estate could be treated as a capital gain transaction.

Income shifting may also be used to reduce the phase-out of tax benefits that apply to many higher income taxpayers. For example, the ability to fund a Roth IRA is phased out for married taxpayers with a modified adjusted gross income of over $150,000. If the shifting of income took the taxpayer below the limits for any applicable deductions or tax benefits, it could provide an additional advantage to the donor.

Income shifting does carry some risks. For example:

Clients who adopt income shifting strategies should make sure the transactions have economic substance, do not run afoul of the “assignment of income doctrine,” and do not result in the IRS’ reconfiguring the transaction  to avoid the evasion of taxes or to clearly reflect the taxpayer’s income. If these doctrines and rules are violated, the client may remain taxable on the income that was supposedly shifted to lower-bracket taxpayers.

In creating such structures, planners should keep in mind the state income tax ramifications of shifting income. Many states have begun taxing nonresidents on the income distributed from local flow-through business entities. For example, Georgia requires that nonresident owners pay income taxes on the income distributed from some S corporations, partnerships, and LLCs. While forum shopping for estate tax and asset protection purposes has been in vogue for some time, clients may also use forum shopping to minimize any state and local income tax liability.

Payments of unearned income to beneficiaries who are under age 14 can result in the income taxes being calculated using the parent’s income tax bracket, not the child’s bracket.

The client must give up the income. In most cases, income shifting makes sense only if the client is willing to forgo future income and/or if the client is already funding a need of a lower-bracket taxpayer (e.g., nursing care costs).

The increased focus on basis. The cost basis of assets generally is stepped up to their fair market value (FMV) at the time of death. The new higher estate tax exemptions frequently mean that less of an estate is subject to federal estate tax. As a result, a quantum shift in tax planning may occur. Instead of lowering the value of assets to reduce transfer taxes, clients may actually want to increase the value of assets to obtain a higher basis step-up. The higher basis will reduce the income taxes paid by heirs on the sale of inherited assets and will create new depreciable values for depreciable assets.

Planning example. A chronically ill father owns 40% of a family business worth $3 million. Assume the available estate tax exemption is $2 million and a 40% discount would apply to the father’s ownership interest. Also assume there is a 10% control premium. His wife and heirs own the remaining 60% of the business. Wife transfers 11% of the business ownership to the husband as a marital gift. The husband’s will provides that the amount of his estate tax exemption equivalent is placed in a spray trust for the benefit of the wife and descendants. If the father dies before the transfer, the value of his interest in the family business would be $720,000 (i.e., $3 million times 40% times 60%). If the 11% interest is transferred, the effective value of the 40% stock interest would be $1,320,000. The creation of a controlling interest creates an additional $500,000 of basis.

It will be a crazy world in which the IRS and tax practitioners will be swapping asset valuation arguments. Moreover, techniques such as intentionally defective grantor trusts will be turned on their heads to become Estate Defective Trusts (discussed later).

Charitable bequests and IRD. When clients want to make a charitable bequest, they should consider funding that bequest with qualified retirement plan assets or other assets that would have created “income in respect of a decedent” (“IRD”). Because of the current rules on naming beneficiaries of retirement accounts, the client is best advised to bifurcate any IRA into an account that names a charity as beneficiary and one or more other accounts that name noncharitable beneficiaries. If the client either does not want retirement assets to go to charity or does not have retirement assets, the will or living trust could provide that any charitable bequest first be funded from IRD assets to the extent the estate or trust held or receives such assets.

Planning example. A client wants to pass $30,000 to a charity at his death. He holds an IRA worth $25,000. The client could name the charity as beneficiary of his IRA and provide in his will that the estate pay to the charity the difference between $30,000 and the IRA value at his death. Assume the IRA was worth $20,000 at death and the client’s only heir is in a 40% state and federal income tax bracket. The passage of the $20,000 in IRA funds to charity would save the heir up to $8,000.

Investment decisions. Investments in trusts and estates may be changed to investments that are more tax-effective. Net after-tax returns will become a critical part of investment evaluations. For example, fiduciaries will be more prone to use tax-efficient mutual funds and capital gain investments rather than those that may be taxed at higher ordinary income rates, particularly when trusts and estates will be accumulating income.

This trend is already evident in the growth of total return trusts. One motivation for total return trusts is the desire to move away from strict definitions of income and principal that tend to distort fiduciary investment decisions. When fiduciaries are free to make the best economic decisions to produce the highest after-tax return, the net return to all beneficiaries should increase. (Total return trusts are discussed more later.)

Not only the form of the investment (e.g., stocks or bonds), but also the tax vehicle that holds the investment may be important. In an appropriate situation, Roth IRAs, charitable remainder trusts, health savings accounts, Coverdell savings accounts, and Section 529 plans  can offer tremendous tax savings.

The impact on the use of trusts

This new tax environment is also changing how clients and planners approach the use and creation of trusts. Trusts remain one of the most adaptable planning tools available. As a result, clients will continue to use trusts to accomplish both tax and nontax estate planning goals. Income tax planning opportunities using trusts will increasingly become part of the estate planning process. Among the expectations are the following:

`Spray trusts.’ As discussed earlier, the new tax environment will encourage the allocation of income to lower-bracket taxpayers. The use of a trust spray power to allocate income among various family members (particularly those in lower tax brackets) will be an increasing part of the planning process. Accordingly, a college student who is in a 10% income tax bracket may be sprayed income from a trust, resulting in more after-tax dollars to fund the child’s college education.

Planning example. A client intends to create a trust, contributing an asset that has a value of $500,000 and a basis of zero. The trust will sell the asset for an installment note payable annually over ten years at 8% interest. The trust is intended to provide for the college education of grandchildren who will not begin college for 11 years. Assume that the grantor’s state of domicile will impose an 8% tax on the income and capital gains retained in the trust. The grantor is considering establishing the trust in Delaware—a state that does not impose taxes on trusts that accumulate income for nonresident beneficiaries. If the trust is set up in the donor’s state, the state income taxes over the next ten years will be almost $60,000. If the trust were formed in a nontaxable state, such as Alaska, Delaware or Florida, there might be no income tax liability.

Fiduciary income tax issues. Income tax planning will become a higher priority for the majority of estates and trusts. For example, advisors will also need to examine estate and trust investments based on the relative after-tax returns.

Planning example. A trustee intends to accumulate trust income for ten years until grandchildren of the grantor reach college age. The trustee has two investment choices: an ordinary income investment that generates an 8% return and a capital gain investment that generates a 6.5% annual return. The trust is in an ordinary income tax bracket of 35%, while the capital gain rate is 15%. Ignoring any other investment or tax issues (e.g., trust deductions, investment risk, diversification, etc.), which is the better investment? The net after-tax yield on the ordinary income investment is 5.2%, while the net after-tax yield on the capital gain investment is 5.5%.

Estate Defective Trusts. For years, clients and planners have used intentionally defective grantor trusts, which cause the trust’s income to be taxable to the grantor while the transfer of assets to the trust is complete for estate tax purposes. The objective of such trusts, which I will refer to as “Income Defective Trusts,” is to reduce a client’s federal estate taxes.  An Income Defective Trust uses the differences in the income tax and estate tax rules  to create a trust that remains taxable to the grantor for income tax purposes (pursuant to Sections 671-678), while the trust assets are removed from the grantor’s taxable estate.

However, with the recent increases in the applicable exemption amount (and with more increases still to come), the gap between the income tax and transfer tax rules may create planning opportunities for “Estate Defective Trusts” (“EDT”). Such trusts are intentionally created to have the trust income taxable to the trust or its beneficiaries, but to have the trust assets remain in the grantor’s taxable estate.

An EDT has two major income-tax-related benefits. First, the tax on the income of an EDT is allocated to either the trust or its beneficiaries. Unlike an Income Defective Trust, the EDT can effectively permit a grantor to use the lower income tax brackets of the trust beneficiaries to reduce the overall taxes of the family.

Planning example. A client has a grandchild in college, and the client owns an asset that generates an annual income stream of $40,000. The client is in an effective income tax bracket of 40%, while the grandchild is in an effective income tax bracket of 15%. Using an EDT, the family saves $10,000 in annual income taxes. If the grantor were paying Social Security or self-employment taxes (e.g., by being the manager of an LLC), the savings would be even more significant.

Not only are income taxes reduced, but the after-tax proceeds from the income are not includable in the grantor’s estate, reducing the possibility that the grantor may be subject to either state or federal transfer taxes.

Planning example. Assume in the above example that the client dies in 20 years, but retained the asset that generated $40,000 in annual income until his death. Assuming an annual 6% return, the annual after-tax income (even at a 40% income tax rate) from the asset could create an additional estate value of over $685,000 at the grantor’s death.

Second, many clients hold low-basis assets (e.g., a family farm or business). The client may desire to gift the asset to family members, but does not want to lose the benefit of the step-up in basis which occurs at death. The client can place the asset in an EDT. Beneficiaries will receive the current benefit of the asset, but the asset will remain part of the grantor’s taxable estate, permitting a step-up in basis.

Planning example. A client owns a business that has a zero basis, but is worth $500,000. The business is growing at an annual rate of 5%. The client’s son is taking over the business. If the father gifted the asset to his son, the son would take over the father’s zero basis. Assume the father dies in five years, when the business is worth $640,000. By placing the business in an EDT, if the son sold the business when he was in a 20% effective tax bracket, he would save $128,000 because of the EDT.

Conclusion.  Benjamin Franklin said that only taxes and death are inevitable. As long as we have taxes, tax avoidance will remain an important motivation for many people.  This does not mean that planning does not continue on in preserving and protecting your assets.

Business/Tax Law Issues assignment of income doctrine, Charitable bequests, depreciable assets, Estate Defective Trusts, federal estate tax exemptions, federal income tax bracket, income in respect of a decedent, IRA, IRD, new depreciable values, preserving and protecting assets, Social Security taxes, state and, taxpayer's income, unearned income to beneficiaries

Asset protection of business and investments assets are a significant factor in the choice of the formation of a legal entity.  A major consideration is when an outside creditor (a creditor that does not deal with the business entity directly) attempts to levy indirectly on assets that are owned by a limited partnership, corporation or limited liability company by attaching the equity interest of the business owner (partnership, shareholder or membership interest).

Under the laws of most states, the creditor of a limited partner is unable to seize ownership of the limited partner’s interest in the partnership. Instead, the creditor receives an order from the court (“charging order”) which instructs the partnership to give the creditor any distributions that would otherwise be paid to the debtor limited partner. The court generally will not have the authority to order that distributions be made. The law in many states also provides that similar protection applies to limited liability company (“LLC”) interests.  Note, that this is generally not true for corporations, except for certain corporations formed in Nevada.

No Silver Bullet Consideration. As was pointed, in a recent article discussing charging order protection by Alan S. Gassman and Sabrina M. Moravecky they noted that there are not a great number of reported cases on this subject.  This is due to the fact that most creditors and debtors negotiate and come to terms when the possibility of a charging order arises. Charging orders are established by courts of equity, and such courts typically have significant discretion in implementing equitable remedies.

In order to be able to achieve a more favorable outcome in negotiations, charging order protection is a fundamental factor in favor of utilizing either a limited partnership or LLC.  This does not mean that a charging order is a total silver bullet for asset protection purposes.  It means simply that there is another round of negotiations between the parties.

Conflict of law Consideration.   I have often been asked whether or not it is better to form a limited partnership or LLC in other states rather than California.  I often reply that conflict of law jurisprudence determines which state’s law should apply, depending on the state of residency of the creditor, the debtor, and the subject LLC or limited partnership. If you residence in California, your assets are located in California as well as the creditor suit, more often than not California law will apply compared to other’s state favorable charging order statute.  I do form limited partnerships and LLC in other states for many different reasons not discussed in this article.

Tiered Entities Consideration.  Rather than having a business owner own an interest in an LLC or limited partnership directly, he or she should consider having a “family” or “intermediary” LLC or LLP hold an owner’s partial partnership interest in another such entity. For example, if a owner owns 25% of an LLC and has charging order protection under a judgment, the owner is unable to control whether the remaining members may choose by majority rule to make a distribution that the owner’s creditor would receive the owner’s share of. However, if the owner owns 95% of an FLP that owns 25% of the above referenced entity, then the 25% distribution would pass from that entity to the FLP and could be re-invested if charging order protection applies at the FLP level.

Fraudulent transfer statutes. While fraudulent transfer statutes may commonly permit creditors to unwind transfers made for purposes of creditor avoidance, if a owner owns an interest in a company that becomes an LLC, which simply receives a charging order protective interest in exchange for a non-charging order of protective interest, fraudulent transfer statutes may not apply to such a transition.

LLCs that are owned by individuals in different states may or may not be protective for each owner. The law of the state where each member resides may be controlling as to charging order protection. In many cases, limited partnerships may be preferable because of better established charging order protection rules.

Conclusion More and more sophisticated owners have seen their colleagues, competitors, and family members fall to predatory creditors, and have witnessed the United States court litigation system, leveraged real estate, and industry failures. Informed owners will select entities with reference to incidental creditor protection features, regardless of whether said protection is a primary motivation for implementation and use. As owners grow to expect that charging order protection will be applicable to such entities, they must analyze the specific rules that apply in the jurisdiction of the entity’s operation and the jurisdiction of residency of each member/partner in order to determine how to select, design, and operate a given entity arrangement.

Business/Tax Law Issues asset protection, business and investments assets, charging order, Conflict of law Consideration, equitable remedies, legal entity, Michael Trainotti tax lawyer, partial partnership, Tiered Entities Consideration

In June 2009, the tax court in the Estate of Miller v. Commissioner, allowed a discount of 35% where marketable securities were transfer into an FLP about 13 months prior to the decedent’s death. The court concluded that there were legitimate and significant non-tax reasons for the contributions to the partnership, finding credible the witnesses’ testimony.  However, it denied any discounts that were contributed to the same FLP just 13 days before the decedent’s death.

The court emphasized that (a) there was active management of the partnership’s assets by the decedent’s son as the general partner, (b) there was a change in the investment activity after formation of the FLP and (c) the decedent retained sufficient living expenses separate and apart from the FLP’s assets.  Below is review of this case from Steve Leimberg’s website.

FACTS: H devoted his time following retirement to researching and investing securities and used a specific charting methodology to purchase and sell securities “on the basis of an analysis of their daily high and low values.”  H died on February 2, 2000 with a gross estate of about $7.67 million, 99.6% of which was securities held by his revocable trust.

H had taught the oldest son his special charting and securities management process, and W wanted the oldest son to continue managing the family assets using that process after H died. The oldest son actively managed the securities in MFLP (through his wholly owned company). He devoted about 40 hours a week to the management of the partnership assets, including continuing the sale and purchase analysis based on his father’s charting system. Before W contributed assets to MFLP, her accounts made very few trades, and “trading activity increased after the securities were transferred to MFLP.” However, the actual trading activity was relatively small (”about $3,000 to $4,000 per month”), representing sales and purchases of only about 1% per year of MFLP’s securities.

On April 25, 2003, W fell and broke her hip. As with a lot of people in their 80s who suffer broken hips, various serious health problems followed. Within days, W had pacemaker implantation surgery and a subsequent surgery to repair her hip. A week later, W was moved from the hospital to a continuing care facility, but returned to the hospital on May 12, 2003 with congestive heart failure. On May 19, 2003, a CT scan revealed a traumatic brain injury, and W died on May 28, 2003.

Issues and Holdings:  The approximate $4 million of contributions to MFLP in April 2002 (13 months before W’s death) qualified for the bona fide sale exception to §2036 because the driving force in the creation of the partnership was to continue H’s special approach to investing the securities and not tax savings.

The approximate $878,000 of contributions made in May 2003 (13 days before W’s death) did not qualify for the bona fide sale exception because “the decline in her health and the decision to reduce her taxable estate were clearly the driving forces” behind the contribution.  Section 2036(a)(1) was triggered, primarily because of the use of partnership assets to pay W’s federal and state estate taxes.

Business Not Required; Marketable Securities Partnership.  The IRS argued that the trades MFLP actually made were not sufficient “to qualify MFLP as a legitimate operation.”  Also, it argued that the types of assets (i.e., marketable securities) weigh against the finding of a valid non-tax business purpose.  The court disagreed.  “The non-tax purpose behind formation of MFLP was to continue Mr. Miller’s investment philosophy and to apply it to family assets. This goal could not have been met had decedent not transferred securities to MFLP.”

Planning Implications from Miller. If possible, include the following in the planning structure: (a). Change the management of the assets in some significant manner. (b) Provide for active management rather than merely passively holding partnership assets. (c) Do not transfer all (or almost all) of the owner’s assets to the partnership. (d). Retain assets for living expenses and (e) Retain assets for paying estate taxes (or at least a substantial part of the estate taxes, or make arrangements for other family members to purchase the decedent’s interest in the FLP without using the FLP’s assets

Business/Tax Law Issues active management of the partnership's assets, general partner, marketable securities, researching and investing securities, revocable trust

The current economic climate has really been a challenge for many people are facing either a career change, delays in retiring as planned, or simply having to go back to work.  Not surprisingly, starting a new business may be the one true viable option given the current job market and employment rate.

This article will be one in a three-part series dealing with business entity choice, change in the limited partnership law effective January 1, 2010 and dividing up a business tax-free for asset protection purposes. The current article below is from RIA dealing with business entity selection dealing with some very basic points.

C corporation vs. Partnership, Do you plan to do business through a corporation or partnership? If so, you need to determine which entity will work best for you—a C corporation or a pass-through entity like a partnership, Limited Liability Company (LLC) or S corporation. Both corporate and individual tax rates are graduated beginning at 10% for individuals and 15% for corporations and going as high as 35% for individuals, and 38% for corporations (after considering the corporate surtax). (Personal service corporations are not eligible for graduated rates and pay a flat 35% rate.

By organizing the business as a C corporation and splitting the business income between the owner(s) and the corporation (e.g., by having the corporation pay reasonable compensation to the owners and/or paying interest on loans from the owners of the corporation part of the business) the income will be taxed at the lowest rates applicable to each. Total federal income taxes payable will usually be lower than if the business was a sole proprietorship.

But other factors need to be considered. For instance, if the organization will distribute all the profits of the business to the owners, it is usually better that it not be a C corporation, since corporate shareholders are subject to an additional tax on dividend distributions from the corporation. If the organization is expected to incur tax losses, it is important to structure the organization in a manner which would allow the maximum benefit from the tax losses. For instance, if the owners of the business have other income, it is often better to structure the organization as a pass-through entity in order to allow the owners to offset their other income with the losses of the business  On the other hand, if the owners of the business will not be able to use the losses to offset other income, e.g., because they have no other income or because of rules preventing the use of the losses, such as the rules which limit the deduction of capital losses from ordinary income or the passive loss rules it may be preferable for the organization to be taxed as a corporation, since it will be able to offset its future income with the losses.

There are some other advantages of C Corporation status: C corporations may deduct nontaxable fringe benefits paid to shareholder-employees, while pass-through entities are sometimes not eligible for this type of deduction.  Similarly, corporations are allowed a dividends-received deduction while pass-through entities are not. Finally, pass-through entities are limited in the taxable years they are permitted to, while C corporations (other than personal service corporations) are generally allowed to adopt any taxable year.

Partnership vs. S corporation.  Have you decided to do business through a partnership or S corporation? If it is important that the owners of the business be protected from unlimited liability, you are likely to be better off structuring the entity as either an LLC that is taxed as a partnership or an S corporation, rather than a partnership. However, in various situations, an LLC that is taxed as a partnership has advantages unavailable to S corporations.

The rules on which corporations are eligible to make the S corporation election may preclude many organizations from becoming S corporations. For instance, any organization which has a foreign owner, an owner who is not an individual (other than certain trusts), or more than 100 owners, will not be eligible to make the S corporation election.

An S corporation is generally not allowed to have more than one class of stock. Therefore, an S corporation does not have flexibility in giving different shareholders different interests. In contrast, a partnership may give different partners different percentages of different types of income, subject to certain anti-abuse rules.  A partner may deduct his share of partnership losses up to his basis in his partnership interest which generally includes the partner’s share of indebtedness incurred by the partnership. In contrast, a shareholder in an S corporation may deduct his share of the S corporation’s losses up to his basis in his stock and his basis in debt the S corporation owes him (but not including his share of debt the S corporation owes to others).

A general partner is subject to self-employment tax on his share of partnership income (other than non-trade or business income items such as dividends and interest), while a limited partner is subject to that tax on guaranteed payments from the partnership that are for services he performs. Proposed regs would generally treat individual members of an LLC who are not managers as limited partners. A shareholder of an S corporation isn’t subject to self employment tax.

No income tax is imposed at the partnership level. No tax is generally imposed at the S corporation level, except for California’s 2.5% tax . However, the S corporation itself may be taxable on certain items such as built-in gains and excess passive income.

Business/Tax Law Issues business entity choice, C corporation, C corporation vs. Partnership, LLC, pass-through entity, S corporation, self-employment tax, sole proprietorship

The Uniform Limited Partnership Act of 2008 (Re-RULPA) became operative on January 1, 2008 and governs domestic limited partnerships that are formed on or after that date.  It also governs all foreign limited partnerships as of January 1, 2008. Re-RULPA will govern all limited partnerships in California on and after January 1, 2010.

A limited partnership formed before January 1, 2008, (a “legacy limited partnership”) may elect to be subject to Re-RULPA in the manner provided in its partnership agreement or by law for amending the partnership agreement.  In any event, it will become subject to Re-RULPA on and after January 1, 2010.

When a legacy limited partnership elects to be subject to Re-RULPA, however, certain provisions of the Act, by default, will not apply to the limited partnership at any time (even after January 1, 2010) unless the partners specifically agree to them in the manner provided in the partnership agreement or by law for amending the partnership agreement.  Thus, if such an electing limited partnership wants to have a perpetual duration, it must specifically agree to such a provision when opting to come under Re-RULPA provisions defining when a person may dissociate as a limited partner; what it means when one is dissociated as a limited partner; defining when a general partner may be dissociated in certain cases by unanimous vote or judicial order; and when a limited partnership can be dissolved following the dissociation of a general partner.

The potential target groups at which Re-RULPA was aimed, or enterprises that would work well under it, has been noted in California Continuing Education for attorneys for planning purposes as follows:

Re-RULPA is a stand-alone act, no longer linked to the general partnership statutes.  This change is expected to create a specialized body of law over the long term that will help promote greater certainty than exists today in the area of limited partnerships.

Re-RULPA no longer requires a business purpose for a limited partnership, thus broadening the flexibility of its potential uses.

Re-RULPA provides for a limited partnership to have a “perpetual existence,” thus facilitating continuity for an entrenched management.

If a person dissociates as a limited partner, his or her interest becomes that of a mere transferee, which is an interest that has very few associated rights.  A dissociated limited partner has no right to force a cash-out of this interest and therefore tends to be locked in to the partnership arrangement.

The dissociation of a general partner does not by itself cause the limited partnership to dissolved, and the Act provides more safeguards than does its predecessor, CRLPA, to prevent a dissociation from leading to a dissolution.  This change also furthers the long-term stability of the enterprise.

The fiduciary duties of a general partner are carefully circumscribed and clearly defined, with the aim of promoting greater certainty in how general partners should act.

The information rights of limited partners under Re-RULPA are clearly and comprehensively described, with the general partners having an affirmative obligation to volunteer to any limited partner from whom a consent is sought (without necessity of a demand) all material information known to the limited partnership relating to the subject matter of the consent.

Re-RULPA includes provisions relating to public notice of limited partnership events that give conclusive effect to certain forms of constructive notice resulting from filings in the public record.  This affords definite and clear ways for notice to be given of the dissociation of a general partner (depriving that dissociated general partner of apparent authority to create further obligations on behalf of the limited partnership) and of similar important events affecting the limited partnership.

For a small businesses, a Limited Liability Company (“LLC”) is a good option rather than a limited partnership, especially if the general partner is an individual.  The LLC option is not necessarily the best, however, since California LLCs pay annual fees tied essentially to any gross revenues exceeding $250,000, and these fees can exceed $10,000 per year if revenues exceed $5 million.  It may be preferable from a cost-benefit perspective in such cases to choose a limited partnership with a “1 percent general partner” (corporation or LLC) to achieve the limited-liability goals of the venture in protecting the general partner.

Legacy limited partnerships that do not affirmatively elect to be governed by Re-RULPA will nonetheless become governed by Re-RULPA beginning January 1, 2010, except that they will not be governed by the provisions itemized in Corp C §15912.06(c) unless they specifically act to amend their agreement to be so governed.  This should enable a legacy limited partnership to function under Re-RULPA without becoming bound by certain of Re-RULPA’s potentially more disruptive changes in the law.

PRACTICE TIP: Given the significance of these changes, and their mandatory nature on and after January 1, 2010, you should consider how the mandatory conversion may affect your legal status and should consider taking affirmative steps to review with them the implications of such a conversion.

Business/Tax Law Issues CRLPA, dissociated limited partner, domestic limited partnerships, legacy limited partnership, Limited Liability Company, limited partnership, limited partnerships in California, partnership agreement, Re-RULPA, The Uniform Limited Partnership Act

If you are like everyone else who has owned both stocks and real estate, the last few months have been terrible.  Most individuals I have talked to have had their dreams changed.  Some have been very dramatic. Younger individuals or couples have a much longer horizon to hopefully recoup their money, while the older generation must make adjustments that they thought they would not have to face.

Does estate plans reflect current intentions?  Tax professionals encourage their clients to review their estate plans frequently. Recent events have made such a review more important than ever, as changes in tax law and asset values may well have made the individual’s plan diverge substantially from its original path.  In a recent article by PATRICK J. LANNON and MICHAEL C. GERSON entitled “JITTERY MARKETS—AND CLIENTS—CREATE NEED FOR FLEXIBLE ESTATE PLANS,” the authors discuss the need for individuals to still plan but have more flexibility.  Some of their comments are below.

Estate tax changes.  Since 1997, the applicable exclusion amount has risen from $600,000 to $3.5 million. As a result, existing estate plans that create separate “bypass” and “marital” trusts or otherwise intend to take advantage of this exclusion should be reviewed to make sure that this huge change has not had an unforeseen impact on the planning.

For example, individuals with smaller estates may want to eliminate trusts that were added for tax purposes but never favored by them. Given the expanded applicable exclusion amount, individuals with more modest wealth may wish to revert to their preference for holding assets jointly rather than separating them to make sure each spouse’s exclusion is used. Such planning should, of course, take into account the possible loss of step-up in basis for capital gain tax purposes on the death of an owner, as well as the loss of the various other benefits of planning with trusts such as creditor protection for beneficiaries.

In standard marital planning, the marital trust may now be much smaller than contemplated. As a result, the surviving spouse may receive much less income than expected. A client with modest wealth who still wants to create a credit shelter trust but is concerned about his or her spouse having sufficient assets may wish to name his or her spouse as sole beneficiary of the credit shelter trust, with a power of appointment in favor of descendants. This should give the spouse a greater sense of security while retaining many of the benefits of the more common “sprinkle” trust.

“Minimal impact” estate planning.  Not all individuals will be looking for ways to obtain more assets for themselves or family members. They may be concerned in the current economic environment that advanced estate planning strategies will commit them to excessive current or future outlays. Many advanced strategies involve giving property away, so individuals run the risk of depleting assets that will be needed later to support their lifestyles. This concern may be especially strong for persons who are wealthy on paper but have few liquid assets available to spend. They may be surprised to learn that some estate planning strategies can be customized to minimize the impact of the planning on their enjoyment of their property.

One common gift-giving strategy that has a minimal impact on client enjoyment of property is gifts or discounted sales to family members of non-voting stock in a family business, or of partial interests in real property. With proper attention to avoiding estate inclusion due to retention of an interest, these gifts or sales may remove assets from a client’s estate while minimizing the impact on his or her enjoyment of the property.
“Toggle” strategies.  Some of the most powerful estate tax avoidance strategies require a continuing commitment from the client that may last for years. Individuals wary of future outlays may be reassured that some strategies may include a “toggle” feature, such that they can be turned off and perhaps on again.

One of the most common estate planning strategies is annual gift giving, intended to take advantage of the annual exclusion for gift tax purposes (currently $13,000 per donor per donee) or the Section 2503(e) exclusion for payments to medical or education providers. Some people may continue or begin a regular course of annual gifts, but a cautious individual will take care to avoid making beneficiaries dependent on the regular support.
An individual may be reluctant to begin a gift-giving program that he or she will not feel free to end if their net worth should fall. Annual exclusion gifts to trusts, whether through the use of Section 2503(c) or “Crummey” powers, can moderate this risk by allowing a build up within the trust of assets contributed as gifts, with trustee oversight on withdrawals. This feature, together with the asset protection and other beneficial features of trusts, may convince a client to accept the additional complexity of a trust. With such a trust, a client with a falling net worth can stop the gift giving at any time and rely on the built-up asset value from prior gifts to smooth out the impact on the beneficiaries.

An individual may also create a lifetime grantor trust with a feature that allows grantor trust status to be removed if the client in the future does not feel that he or she has sufficient assets to shoulder this liability/continuing gift.

Business/Tax Law Issues

I attended the USC Tax Institute last month.  One of the major themes dealt with certain types of favorable tax planning options during the current economic downturn.  The planning was based upon two principles.  The first dealt with the idea that an individual believed that the depressed value of his or her stocks or real estate will appreciate sometime in the future.  The second principle was that if a gift was going to be made that the income stream from the asset involved would remain steady.  This is very important as will be discussed in the first example and not so important in the second dealing with a personal residence.
Interest rates have dropped significantly in recent months and should remain low given the state of the economy. Sagging rates can have a significant impact on many tax and estate planning strategies. Lower interest rates affect the income, estate and gift tax value of many types of transfers. In many cases, the drop in rates produces more favorable results for individuals engaging in certain types of transactions. In other cases, however, the lower rates result in higher tax costs. Likewise, stock values and real estate generally have declined significantly and also have affected various time-tested tax moves. This article examines how low interest rates and the depressed stock market or real estate affect key tax and estate planning transactions and strategies.  I will discuss only two types of strategies in this article and how the interest rate impacts the planning.
Grantor retained annuity trust (GRAT). An individual can save transfer tax by setting up a GRAT. The individual retains an annuity interest for a specified term at the expiration of which the trust property goes to a child or other individual named at the outset. Gift tax is payable but only on the present value of the remainder interest, which is the value of the property transferred to the trust less the value of the retained annuity interest. A lower interest rate increases the value of the annuity retained by the grantor and thus reduces the value of the gift of the remainder in a GRAT.
The post-transfer appreciation in the value of the trust assets will escape transfer tax. However, this is so only if the grantor survives the trust term. If the grantor dies during the trust term, the trust property will be included in his gross estate under Code Sec. 2036(a) , which provides that property transferred by an individual during his lifetime is includible in his estate if he retains an interest for any period that does not in fact end before his death. But an individual who sets up a GRAT and dies before the end of the term would be no worse off than if he had not entered into the transaction except that he will have incurred the costs of setting up and administering the trust.
Example.  When the Code Sec. 7520 interest factor is 2.2%, Smith transfers $1 million to a trust, which is to pay him an annual annuity of $80,000 for 10 years. At the end of the 10 years, the trust property is to go to Smith’s daughter. The value of Smith’s retained annuity is $711,144. This figure is determined by multiplying $80,000 by 8.8893, which is the annuity factor from Table B of IRS Publication 1457 for a 10-year term and an interest rate of 2.2%. The value of the gift of the remainder to Smith’s daughter is $288,856.  By way of comparison, had Smith made the transfer when the interest factor was 6.2%, the value of the gift would have been $416,736.
Grantor retained income trust (GRIT).  A GRIT is like a GRAT except that the grantor retains an income interest instead of an annuity interest. Code Sec. 2702 generally treats the grantor as making a gift of the full value of the property. However, the value of the gift of the remainder is determined under the valuation tables where the trust is funded with a personal residence of the grantor or the remainder goes to someone falling outside of the definition of family member, such as a nephew or niece. A lower interest rate results in a lower value for the retained interest and a higher value for the gift of remainder interest in a residence GRIT or other GRIT excepted from the Code Sec. 2702 rules.
Example.  When the Code Sec. 7520 interest factor is 2.2%, Bailey establishes a personal residence GRIT, retaining a ten-year term interest. At the end of the 10-year period, the residence is to go to his son. The value of the residence at the time of the initial transfer to the trust is $400,000. The remainder factor from Table B of IRS Publication 1457 is .804435, making the value of the gift $321,774. Had Bailey engaged in the same transaction when the interest factor was 6.2%, the value of the gift would have been $219,187. Thus, higher rates actually produce a better result for this strategy than when interest rates are lower. As a result, a person may want to wait until interest rates rise before engaging in this type of transaction.

Business/Tax Law Issues

In November I attended a tax seminar in San Francisco.  One main topic that was discussed during the event was - What is the new administration is going to do regarding the repeal of the estate tax and related matters?  Below is some recent information from various tax services I use that sets forth some of the comments mentioned in the tax seminar.  What this will mean is that a husband and wife will be able to transfer $7 million to their children free of death taxes starting next year.

One major point I would like to stress from the tax seminar is that now may be the best time to do gifting.  The reasons are basically two fold.  First, the value of your assets may be at their lowest point in years.  If you believe that they are going to increase over the next few years then this is a major factor to make a gift.

Second, is that the next administration may want to follow through with what the Clinton administration failed to do by trying to eliminate valuation discounts.  This is potentially a big deal and the window to take advantage of this may only last a few more months.  The second discussion below on valuation discounting points out the possible time limitation for gifting.  Starting in 2009 the annual gifting exclusion amount will increase to $13,000 per person!

Barack Obama Estate Tax Plan. President-elect Barack Obama includes estate tax reform in his middle class tax cut plan. His estate tax reform plan would (1) eliminate the scheduled repeal of the estate tax in 2010 (and the return of the pre-2001 rates and rules in 2011), (2) preserve the present rules for determining the basis of property received at a decedent’s death, rejecting the application of carryover basis at death, (3) set the applicable exclusion amount at $3.5 million, indexed for inflation after 2011, (4) make the unused applicable exclusion amount of a deceased spouse available to the surviving spouse, and (5) set the top estate tax rate at 45%.

Discounts and Valuations  Discounts are a cornerstone of many estate planning leveraging techniques. A discount is simply illustrated as follows: a 30% interest in a $100 business is worth less than $30 because the minority interest is difficult to market and has no voting control. Has recent market turmoil legitimately increased the level of discounts on certain transactions?

What about valuations? While the decline in the value of marketable assets is pretty obvious, other asset values have also been compromised. To understand the impact, consider an approach of building up a capitalization rate for valuing real estate assets in today’s environment: [Corporate bond rate + Premium for lower liquidity of target asset as compared to bonds generally + Premium for greater management difficulty of real estate + Premium for unique difficulties of assets in question (location, difficulty to liquidate) + Premium for additional management burdens of residential real estate, vacancy and credit risks of tenants in the actual properties involved + Premium to reflect unique factors in 2008 = Total Capitalization Rate.]

Credit risks may be far greater than they have been in years. Unique factors certainly exist in the current market.

For clients that have not yet consummated significant leveraged gift or IDIT sale transactions now may be an opportune time while higher discounts might be justified, asset values may be depressed, and interest rates remain low.

The possibility of more restrictive estate tax rules in the next administration provide further encouragement for clients to proceed and not delay planning.
This may be a unique time in history for the transfer of wealth.

Defer Gifts?  Gift plans to reduce taxable estates should be revisited. Does your client still have adequate assets to continue a planned gift program? Have the client’s retirement assets declined to the point that gifts should be deferred? Should powers of attorney which include broad gift provisions be revised to prevent gifts that may no longer be viable?

Accelerate Gifts?  The opposite situation may also exist. The client’s heirs may have been so negatively impacted by the economic downturn, e.g. job loss, house in foreclosure, etc. that parental (or other benefactor) gifts are essential and the impact on the parent/donor’s economic position of secondary importance.

In such events a gift program, perhaps combined with intra-family loans and other measures (see below) may be urgently needed. If such assistance is important a number of issues should be reviewed with the client:

Reallocate Gifts?  What of gift equalization? Many clients are adamant that gifts between children and their family lines be equalized. However, if one child has lost his or her job and home, these prior mandates may not longer be desirable.  If gift equalization is not mandated should some type of equalization or adjustment for unequal lifetime gifts be provided under the client’s will?

Rethink Fiduciaries?  Who should be named to serve as fiduciary to make the above decisions? If under the client’s current power of attorney gifts by child family line were mandated to be equalized, the client may have had no problem designating children, perhaps in age order, to serve as agents.

However, if gifts are to be made based on need, or other more qualitative or flexible criteria, the client may wish to reconsider the use of a more independent fiduciary.

Similarly, if a sprinkle trust is to be used under the client’s will to informally address some type of equalization, an independent trustee might be desirable, or depending on the distribution standards essential.

Business/Tax Law Issues

Does an individual’s asset protection planning also mean that his or her business is protected? The answer is no. Sorry, there simply is no silver bullet for everything.

If a business or professional practice owned by an individual is sued, it puts the assets of the business or professional practice at risk. Any personal-level asset protection planning he or she has in place will not protect the assets of the business or professional practice from the judgment creditors of the business or professional practice. It is really that simple.

In a recent article discussing the business planning protection compared to the individual level planning Barry S. Engel, John R. Garland, and Edward D. Brown listed various opportunities for planning purposes. I have provided some of their suggestions below.

Overview of Business Planning Techniques. The operating business or professional practice (hereinafter referred to as the “Company”) is often, by its very nature, a potential target of lawsuits and other legal process. A lawsuit may be brought, for example, by a customer or client, a supplier, a competitor, a governmental agency, or other third parties. Whether the Company is organized as a corporation, partnership, limited liability company or other recognized entity, it can find itself a defendant in a lawsuit, with its own assets exposed.
There are a number of ways to protect a Company’s assets with proper business planning. Here are brief descriptions of the relevant techniques:

1. The Company is divided into component parts. A Company’s enterprises may be created as, or later be divided into, multiple entities. As such, a particular operation of the overall business of the Company can be performed within a separate entity. Any liability risk associated with that separate entity’s operations will be limited to that separate entity’s assets. In that case, for example, a creditor of a separate operating entity would not have access to the assets held by another entity or entities, even if the entities have the same owners and related businesses.

2. The Company forms and funds subsidiary limited partnerships and/or limited liability companies. The Company can form one or more limited partnerships or limited liability companies (“LP/LLC”), and contribute assets to these new entities. A creditor of the owner of an LP/LLC will generally face restrictions in accessing the assets held in the LP/LLC.

3. The Company sells assets and then leases them back. An operating Company can sell valuable assets that it uses in its business to another entity or planning structure created by the Company owners, which in turn leases those assets back to the operating Company. As a result, the operating Company can continue to conduct its business, but if it is sued, its everyday tools of the trade will not be owned by it and thus will not be exposed to judgment creditors of the Company.

4. Equity stripping by the Company. Another strategy is to have the Company pledge its assets (e.g., equipment, accounts receivable, notes receivable, inventory, real estate) as collateral for a loan. The loan proceeds are then loaned to the business’s owners, who place them in a protected arrangement, such as in an LP/LLC or in an asset protection trust. In this way, there is less equity value in the Company that could otherwise be exposed to future creditors.

5. The Company distributes accumulated liquidity. One strategy that requires little explanation is to have the operating Company keep its cash on hand to a minimum and to frequently distribute to its owners liquid assets not needed for daily operations. If the Company is later threatened by an unforeseen claim or lawsuit, the Company will already have divested itself of assets, making it unlikely that the distributions could be viewed as fraudulent transfers.

As with any other type of asset protection planning, in order to avoid running afoul of applicable fraudulent transfer law, it is best undertaken when the Company has no claims pending, threatened or expected, and when there are no outstanding judgments of a material amount or nature. The fraudulent transfer laws of most states are based on the Uniform Fraudulent Transfer Act (“UFTA”), which protects present and subsequent—but not future potential—creditors against transfers made with the intent to hinder, delay, or defraud them.

The concepts summarized above, either alone or in combination, can help a Company’s owners protect the Company’s valuable assets and accordingly help the owners protect their investment of blood, sweat, tears and dollars in the Company. This type of planning can also help generate tremendous savings on annual premiums for liability coverage, whether in the nature of general liability coverage, malpractice coverage, or the like.

Business/Tax Law Issues