WealthCounsel Quarterly Q3 2015

Q UA R T E R LY W E A LT H CO U N S E L

VOLUME 9 / NUMBER 3 Q3 2015

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Contents From The Editor..................................................................................................3 Effective Tax Planning For Partnerships: Understanding The IRC §754 Election .................................................... 4 How Pigs Get Slaughtered: Partnership Audit Proceedings Unwind Abusive Tax Shelters............................................10 Climbing The Tax-Efficiency Pyramid To Lower Taxes...................... 14

WC Quarterly MEMBER MAGAZINE Volume 9, Number 2 • Q2 2015

STAFF SENIOR EDITOR Matthew T. McClintock, JD

Before You Pour: A Few Tax Considerations When Decanting…...................................... 18 Today’s Investments In Loyalty Pay Dividends In The Future........ 26 Getting Appreciated Real Estate Out Of C Corporations (Part II).................................................................30 Alaska And Tennessee Community Property Trusts: Understanding These Basis Adjustment Tools And The Uncertainty They Carry.............................................................. 32 The Importance Of Basis: The New Era Of Estate Planning............................................................... 37 To Multiscreen Or Not?................................................................................. 42

EDITORS Jennifer Villier, JD Jeremiah Barlow, JD PRODUCTION EDITOR

IRC Section 280E: A Tax Thorn In The Side Of Marijuana Businesses..................................................................... 45 Marital Planning In The Joint Trust: Balancing Income Tax, Transfer Tax, And Asset Protection Concerns............ 47 Member Spotlight........................................................................................... 52

Caryl Ann Zimmerman ART DIRECTOR

Incomplete Gift, Non Grantor Trusts (aka DINGs, NINGs)........................................................................................ 58 Education Calendar........................................................................................ 63

Ellen Bryant CONTRIBUTING WRITERS Elliot P. Smith, JD, MAcc, MS, CPA Tim Voorhees, JD

WealthCounsel Quarterly is published four times annually by WealthCounsel,

Patrick Murphy, JD, LLM

LLC, P.O. Box 44403, Madison, WI 53744-4403. Comments and questions

Brenda L. Geiger, JD

about WealthCounsel Quarterly may be addressed to the editor at

Ed Morrow, JD, LLM, CFP

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magazine@wealthcousel.com.

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From the Editor...

MATTHEW T. MCCLINTOCK, JD, VICE PRESIDENT OF EDUCATION, WEALTHCOUNSEL

“ ‘Tis impossible to be sure of any thing but Death and Taxes.”

That quote, first spoken by the drunken cobbler Toby Guzzle in Christopher Bullock’s 1714 farce, The Cobler of Preston, and later coopted

by Benjamin Franklin, largely describes the two great priorities of our industry. Some 300 years later many of us spend our days helping families face the certainty of death and taxes and trying to minimize the adverse impact of both (admittedly with varying degrees of effectiveness). In this issue of the Quarterly, we examine tax in its many forms, highlighting some of the tax concerns that drive the trusts & estates and business law industries.

It’s hard to overstate the impact that high, indexing, portable estate tax exemptions has had on the trusts & estates industry. Before ATRA, the uncertain status of the federal estate tax was still a motivator for many estate planning clients. But now that most clients are safely below the federal transfer tax threshold, many believe that capital gains tax and basis management have become “the new estate tax.”

In this issue we will look at the new tax environment and discuss many ways to address clients’ diverse tax planning needs. From a primer on basis to specific strategies for maximizing tax planning opportunities in estate plans, to understanding some of the special tax issues that business owners face, we hope that this issue will give you a few ideas for how you can best serve your clients in the modern trusts & estates and business practice.

One attorney has adapted well, and you’ll meet him in our WealthCounsel member spotlight. You’ll see how he has blended technical tax and sophisticated estate planning with the human element to build the satisfying practice he enjoys today.

One more thing that Mr. Guzzle might agree is certain: uncertainty itself. The tax policies and other bodies of law that affect our clients are fluid. As political and economic realities change, so too does the law. That’s as certain as death and taxes.

Share The Wealth

At WealthCounsel, we want to celebrate a match made just for you.

So now when you refer a new member, we’ll credit you and your referred colleague each one month of membership dues.

And, there is NO LIMIT to the number of people you can refer. Do the right thing, and refer a valued colleague to WealthCounsel today. You’ll each get a free month of membership for simply growing our network and enjoying the value of what your membership delivers.

For more information go to wealthcounsel.com/sharethewealth

“Sorry, I was hoping you’d ask me to join WealthCounsel.”

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When used properly, an IRC §754 election can be an important tool for an estate planning or business planning attorney. It can make a big difference in the tax burden of a company’s partners and should be given consideration whenever there is a sale of a partnership interest, a death of a partner, or disproportionate distributions.

However, due to the binding nature of the election and its potential to affect future tax liability, the election should only be made after a thorough evaluation of the pros and cons.

Effective Tax Planning For Partnerships: UNDERSTANDING THE IRC §754 ELECTION ELLIOT P. SMITH, JD, MACC, MS, CPA, WEALTHCOUNSEL MEMBER SINCE 2013

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THE ELECTION

TAX BASIS OF PARTNERSHIP ASSETS An election under Internal Revenue Code (“IRC”) §754 (“INSIDE BASIS”) saves income taxes by increasing the tax basis of assets owned by a partnership. The election reduces the difference between a partner’s high tax basis in his or her partnership interest and the partnership’s low tax basis in his or her share of the partnership’s assets.

Often this election can save a client significant money.

It should never be overlooked when working with any entity that files IRS Form 1065.

Let’s start with the basics. Two great prongs of partnership taxation are: 1) the “outside basis,” or the adjusted basis of a partnership interest held by the partner; and 2), the “inside basis,” or the adjusted basis of the assets held by or “inside” the partnership.

TAX BASIS OF PARTNERSHIP INTEREST (“OUTSIDE BASIS”) Outside basis is roughly comparable to a shareholder’s tax basis in corporate stock. However, it’s not that simple because a corporation is a tax-paying entity and a partnership is a pass-through entity: Partners incur the tax liability instead of the partnership. Differences include increasing a partner’s outside basis for contributions plus his or her share of income and decreasing his or her outside basis for distributions and losses.

For example, suppose Partner A contributes $20 to a new partnership and during the first year of operation he is allocated $5 of taxable income. The $5 of taxable income is reported to him on a Schedule K-1 and ends up on his personal Form 1040. For simplicity, also assume that the partnership has no debt and no contributions or distributions were made by or to Partner A during the tax year. Partner A’s outside basis would increase from $20 to $25 because of the $5 of taxable income. If Partner A subsequently sells his partnership interest for $25, he would recognize zero gain because his outside basis would equal the sales price. This increase in outside basis prevents a partner from suffering the pain of double taxation – which would occur with a C-corporation paying taxes on its income followed by the shareholder paying taxes on his $5 stock sale.

Inside basis is a partner’s share of the tax basis of the partnership’s assets. Examples include inventory, accounts receivable, machinery, and goodwill. Generally, fixed assets such as furniture and machinery are depreciated over a period of years providing significant tax deductions. Purchased intangibles such as goodwill can also provide amortization deductions. However, these depreciation and amortization deductions can only be taken if the inside assets have a tax basis.

Once the tax basis is exhausted, no further deductions can come from that particular asset. And, upon the sale of a partnership asset with a high inside basis, less gain or additional loss passes through to the partners.

RELATIONSHIP BETWEEN INSIDE AND OUTSIDE BASIS Due to adjustments to a partner’s outside basis based on income, expense, contributions and distributions, the tax basis of assets inside the partnership often equals the partners’ aggregate outside bases. In the previous example, the partnership realized $5 of income; simultaneously we observed an increase in Partner A’s outside basis. The result is that both A’s outside basis and A’s share of the inside basis equal $25 prior to the sale of Partner A’s partnership interest. Several events, however, can cause a disparity between inside and outside basis: (1) the sale of a partnership interest, (2) certain distributions from the partnership, and (3) the death of a partner. The IRC §754 election works to reduce these disparities so that a partner’s outside basis comes closer to matching her share of the inside basis of the partnership assets. On a slightly deeper level, an IRC §754 election also causes the tax equity account on a tax balance sheet to equal a partner’s outside basis when added to the partner’s share of liabilities.

SECTION 754 AND THE SALE OF PARTNERSHIP INTEREST The sale of a partnership interest is frequently the reason for making an IRC §754 election. Often, a purPAGE

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chaser seeks to obtain the same tax benefit that he would receive if assets were purchased outright rather than indirectly as part of a partnership interest. If no election is in effect, nothing happens at the partnership level and the purchaser does not get the benefit of the depreciation, amortization, and/or decreased gain which (in all fairness) should have been his. However, with an IRC §754 election in place, the tax basis of the assets inside the partnership are adjusted according to IRC §743(b) so the aggregate inside basis of the purchaser’s share of assets generally equals the purchase price for the partnership interest.

One of the most important assets to consider when evaluating whether to make an IRC §754 election is goodwill. According to IRC §197, goodwill only has an amortizable tax basis if it has been purchased. Otherwise the tax basis of goodwill is zero. However, if an IRC §754 election is in effect at the time of purchase there is often a significant increase in the tax basis of the goodwill, which could then be amortized over a 15-year period.

Also, an IRC §754 election only impacts the partner who paid real money to the old partner for her interest in the partnership. Any corresponding depreciation, amortization, or other benefit (or detriment) will be included in the new partner’s distributive share of income or loss. That is, any adjustment made to the inside basis of partnership assets under IRC §743(b) due to a sale of partnership interest makes no difference for the other partners in the partnership.

SECTION 754 AND PARTNERSHIP DISTRIBUTIONS An IRC §754 election also affects the tax basis of the assets inside the partnership when certain distributions from a partnership occur. And, in marked contrast with the solitary impact on the one partner who buys her partnership interest, distribution-based adjustments affect all of the partners who remain in the partnership.

However, not all distributions from a partnership cause a tax basis adjustment under the election. According to IRC §734(b), in order for a distribution to cause inside basis to be adjusted as a result of the IRC §754 election, a distribution from a partnership must either (i) cause the partner receiving the asset PAGE

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to recognize gain or loss from the distribution, or (ii) change the basis of a distributed asset.

Generally, under IRC §732, when an asset is distributed from a partnership, the partner’s outside basis is decreased by the tax basis of the distributed asset.

For example, if the partner’s outside basis is $50 and machinery with a tax basis of $12 is distributed, the partner’s outside basis would decrease by $12 to $38.

The partner would then hold the machinery outside the partnership with a $12 tax basis. Sometimes, however, a partner does not have sufficient outside basis to absorb the tax basis of an asset being distributed.

If cash and marketable securities were distributed in excess of the partner’s outside basis a gain would result equaling the excess amount. If an IRC §754 election has been made the resulting gain would cause an increase of the tax basis of the remaining assets inside the partnership.

In a similar situation where assets other than cash and marketable securities are also distributed from a partnership, a partner’s outside basis is first decreased by the cash distributed, and then any remaining outside basis is allocated to the non-cash assets based on their relative market values. If cash and other property is distributed together and the cash exceeds the partner’s outside basis a gain would result and there would be zero basis to allocate to the other property.

The consequence of such distribution is that the distributed assets end up with a new basis less than they had inside the partnership. This situation would cause an adjustment under IRC §734(b) if an IRC §754 election was in effect so that the tax basis of assets inside the partnership would be increased – for the benefit of all partners – by the same amount the distributed asset basis was decreased.

A distribution could also cause an increase in the basis of distributed assets. This could occur only upon a liquidating distribution when a partner’s outside basis is greater than the tax basis of the assets being distributed. In this situation, the distributed assets assume the entire amount of the partner’s outside basis. If an IRC §754 election is in effect, the tax basis of assets remaining inside the partnership would be reduced by an amount equal to the excess of the partner’s outside basis over the inside basis of the assets immediately prior to the distribution.

But what happens when a partner recognizes loss on a distribution? A loss could only occur upon a liq-

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uidating distribution when a partner fully exits the partnership, and when the departing partner gets cash and marketable securities (and no other assets) which equal less than the partner’s outside basis. The result of the loss if an IRC §754 election is in effect is an increase in the tax basis of the assets inside the partnership.

be an important estate planning tool because it can be made after the death of a partner so long as an election statement is filed along with a timely filed partnership tax return in the subsequent year.

SECTION 754 AND DEATH OF A PARTNER

IRC §755 and the corresponding regulations govern the allocation of the tax basis adjustments which result under IRC §743(b) and IRC §734(b) if an IRC §754 election is in effect. However, the process is slightly different depending on whether the adjustment is due to a sale or exchange or transfer on death or whether the adjustment is as a result of a distribution.

If an IRC §754 election is in effect for the year of a partner’s death, a proportionate share of inside basis would also be adjusted in tandem with any tax basis adjustment under IRC §1014(a). Similar to sales or exchanges, the adjustment of inside basis following the death of a partner is governed by IRC §734(b) and benefits only the successor partner who inherits the partnership interest. The IRC §754 election can

SECTION 755 ALLOCATION OF ADJUSTMENT TO SPECIFIC ASSETS

Adjustments that result under IRC §743(b) from the sale or exchange or from a transfer of a deceased

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partner’s interest are treated similarly. First, the adjustment is divided into two different buckets: (i) ordinary income producing property such as inventory and accounts receivable and (ii) capital gain plus IRC §1231 property (real estate or depreciable property used in a trade or business for more than one year). Generally, an amount equal to the built-in net gain or loss is first allocated to the ordinary income producing property (up to its market value), with any remainder allocated to the capital gain and IRC §1231 property. This method of separation into the two different groups causes any discount or premium on the purchase of the partnership interest to be allocated to the capital gain bucket rather than the bucket of ordinary income producing assets. Once the allocation between the two different asset buckets occurs, allocation within the two different buckets takes place based on the amount of gain or loss that would occur if the assets were sold for market value.

Conversely, under IRC §734(b), any adjustment occurring as a result of gain or loss recognized as a result of a distribution is only allocated to capital gain bucket. Once in the capital gain bucket, the adjustment is further allocated based on the relative value of each of the assets. Any adjustment occurring as a result of a change in the tax basis of the distributed assets is allocated between the two different buckets based on the type of asset distributed. For example, if inventory is distributed and assumes a smaller tax basis outside the partnership, only the tax basis of the partnership’s ordinary assets, such as inventory and accounts receivable inside the partnership, would be adjusted.

A DOUBLE-EDGED SWORD Although an IRC §754 election can provide a positive tax benefit, it can also have a detrimental effect if the value of the partnership decreases in the future. If time passes after a partnership makes an IRC §754 election and the value of the partnership is lower than the tax basis of the assets inside the partnership, any sale or exchange, distribution, or transfer upon the death of a partner could cause the tax basis of assets inside the partnership to decrease. Due to the often hazy nature of future values, making an IRC §754 election should be done with caution.

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ADMINISTRATIVE CONCERNS For partnerships that have significant partner turnover, the IRC §754 election can cause significant burden and expense due to the fact that the partnership must maintain separate tax basis records for each partner. That’s because the partnership must maintain separate tax basis records for each partner. These additional records often cause complexity, increased risk for error on the tax return and must be balanced against any tax savings from making the election.

TECHNICAL TERMINATION IRC §708(b) is also a valuable statute that can be used in conjunction with an IRC §754 election when 50 percent or more of the total interest in partnership capital and profits is sold or exchanged within a 12-month period. This is because the sale of such interest causes a partnership to terminate for tax purposes and a new partnership is deemed to be formed.

Under IRC §708(b) the old partnership is treated as contributing all of its assets and liabilities to a new partnership in exchange for the new partnership interest. The old partnership is then deemed to liquidate and distribute its only asset, which is the new partnership interest, to the new partners. This is important because the old partnership files a final tax return and none of the elections of the old partnership are applicable to the new partnership. If an IRC §754 election is made on the old partnership final return the assets inside the partnership could be stepped up to reflect the purchase price without having future uncertainty.

The new partnership would simply take the assets with the increased basis and have no IRC §754 election in place to cause future unwanted results.

MAKING AND REVOKING THE ELECTION An IRC §754 election is made by attaching a statement to the IRS Form 1065 that is filed for the taxable year in which the election first applies. The election is a partnership election and not a partner election. This distinction is important because the election affects all the partners in a partnership and a partnership can only revoke the election by receiving special approval from the IRS, which is only granted under special circumstances.

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When you invite a fellow attorney to WealthCounsel, you’re introducing a world of opportunity to them. Our legal drafting solutions will bring efficiency and professionalism to their practice, while our educational programs are proven to grow and lengthen careers. And we don’t have to tell you how personally and professionally rewarding our member network can be.

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How Pigs Get Slaughtered: PARTNERSHIP AUDIT PROCEEDINGS UNWIND ABUSIVE TAX SHELTERS JENNIFER L. VILLIER, JD, WEALTHCOUSEL LEGAL EDUCATION FACULTY

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Partnership taxation is the default federal tax classification for multi-member LLCs. Most LLCs are taxed as partnerships because of the flexibility and passthrough taxation available to partnerships, which is not characteristic of the corporate form. As a result of the flexibility afforded partnership tax structures, they run the risk of abuse in the form of federally prohibited tax shelters. A number of recent cases, including a U.S. Supreme Court case that is the focus of this article, remind us that tax shelter litigation is still very much a part of many court dockets today.1 In reviewing partnership tax filings, the Internal Revenue Service (“IRS”) may identify red flags that trigger an audit, such as when an abusive tax shelter arrangement or sham partnership structure is suspected.

This article (i) provides a brief overview of federal partnership tax audit proceedings under the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”),2 (ii) discusses U.S. v. Woods, a 2013 U.S. Supreme Court case involving a federal partnership audit where an abusive tax shelter was in place, and (iii) concludes that attorneys should be aware of the characteristics of abusive tax shelters and refrain from assisting in their formation or operation.

FEDERAL PARTNERSHIP TAX AUDIT PROCEEDINGS Although a partnership3 is not a tax-paying entity, it must file a Form 1065 information return to report its income, gains, losses, deductions, and credits. Those tax items pass through the partnership, appear on each partner’s Schedule K-1, and are reported on each partner’s individual tax return. Prior to the enactment of TEFRA, there were no unified audit proceedings for partnerships. Instead, if the IRS identified an error on the partnership’s information return, then it would have to bring a separate deficiency proceeding against each partner, which resulted in duplicative, sometimes inconsistent, proceedings. Pursuant to TEFRA, many partnerships are subject to unified federal tax audit proceedings, which are designed to facilitate partnership tax audits by determining adjustments at the partnership level rather than requiring the IRS to audit each individual partner. Any partnership subject to the comprehensive unified audit proceedings is required to have a tax matters partner.

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The tax matters partner must be a “general partner,” and must either be (i) designated as tax matters partner by the partnership or, if no designation has been made, (ii) the partner with the largest profits interest.4 The unified federal tax audit proceedings generally consist of two stages: a partnership-level proceeding followed by partner-level proceedings. A partnershiplevel proceeding involves the partnership as a whole and is typically held after the IRS has identified an issue with the partnership’s information return. In a partnership-level proceeding, “partnership items” may be adjusted. Once the partnership-level proceeding has taken place, the IRS issues a Notice of Final Partnership Administrative Adjustment (“FPAA”), which is subject to judicial review in the Tax Court, the Court of Federal Claims, or federal district court.5 The reviewing court has jurisdiction over all partnership items, including allocation of partnership items among the partners and determination of the applicability of penalties or additional tax relating to an adjustment of a partnership item.6 Following judicial review, the IRS’s partnership item adjustments become final, and the IRS may initiate partner-level proceedings to make related adjustments to each individual partner’s tax liability.7 A “small partnership” is exempt from the unified audit rules. A partnership is considered to be a “small partnership” if it has ten or fewer partners, each of which is an individual (other than a non-resident alien), a C corporation, or the estate of a deceased partner. Any partnership having a disregarded entity as a partner cannot be a “small partnership,” regardless of its total number of partners. A husband and wife are treated as one partner for purposes of determining whether a partnership is a “small partnership.” Although exempt from the unified audit rules, a “small partnership” can elect to be subject to them.

U.S. V. WOODS8 In a series of recent cases, the unified partnership audit proceedings were utilized in situations involving abusive tax shelters. Two of those cases, Tigers Eye Trading9 and Petaluma,10 were resolved based upon the U.S. Supreme Court’s holding in U.S. v. Woods, and all three have remarkably similar fact patterns.11 The taxpayers in Woods were involved in an offsetting-option tax shelter, a structure intended to create PAGE

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large paper losses that a taxpayer could use to reduce taxable income. By giving the taxpayer an artificially high basis in a partnership interest, the tax shelter enabled the taxpayer to claim a substantial tax loss upon disposition of the partnership interest. The taxpayers in Woods, Gary Woods (the tax matters partner) and Billy Joe McCombs, participated in the tax shelter by engaging in the following series of transactions: They created two general partnerships, one intended to produce ordinary losses (Tesoro Drive Partners) and the other intended to produce capital losses (SA Tesoro Investment Partners).

Acting through their respective wholly owned LLCs, each purchased five 30-day currency-option spreads and contributed them to the newly formed partnerships, along with $900,000 in cash. The option spreads consisted of a long option (entitling them to a sum of money if a currency exchange rate exceeded a certain amount on a given date) and a short option (requiring them to pay the bank a sum of money if the exchange rate for the currency on the given date exceeded a certain amount). The noteworthy feature of the long and short options was that the trigger amounts for each were so close that it was likely that both options would be triggered (or not triggered) on the specified date.

Using the cash, the partnerships purchased Canadian dollars for the partnership created to produce ordinary losses, and Sun Microsystems stock for the partnership created to produce capital losses.

The partnerships terminated the five option spreads and received a lump-sum payment from the bank.

Near the tax-year end, the taxpayers each transferred their partnership interests to two S corporations (one S corporation received both partners’ interests in Tesoro Drive Partners and the other received both partners’ interests in SA Tesoro Investment Partners).

The partnerships, each now having a single partner (the S corporation), were liquidated by operation of law and their assets were deemed distributed to the S corporations.

The S corporations sold the assets for a gain of $2,000 on the Canadian dollars and $57,000 on the stock.

Rather than reporting the gains, the S corporations reported an ordinary loss of $13 million on the sale of the Canadian dollars and a capital loss of $32 million on the sale of the stock. The losses were allocated be-

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tween the taxpayers as the S corporations’ co-owners.

The taxpayers were able to claim such enormous losses because their outside tax basis was greatly inflated.12 The taxpayers had contributed $3.2 million in option spreads and cash to acquire their partnership interests, but, because they omitted the “short” option in their basis computation on the theory that it was “too contingent,” their total outside basis was over $48 million.

Under Code §732(b), the basis of property distributed to a partner in a liquidating distribution is equal to the adjusted basis of the partner’s interest in the partnership (reduced by any cash distributed with the property). Therefore, the taxpayers’ inflated outside basis figures were carried over to the S corporations’ basis in the Canadian dollars and the stock, resulting in the taxpayers’ huge losses when the assets were sold.

The partnerships’ information returns triggered an audit, after which the IRS issued each partnership an FPAA. The IRS determined that the partnerships (i) had been formed and used solely for purposes of tax avoidance, (ii) had no business purpose other than tax avoidance, (iii) lacked economic substance, and (iv) were shams.13 Furthermore, the IRS subjected the taxpayers to a 40% penalty for gross valuation misstatements as a result of inflating the tax basis of their interests in a partnership that, for tax purposes, did not exist.

Woods sought judicial review of the FPAAs. The District Court held that the partnerships were properly disregarded as shams but that the valuation misstatement penalty did not apply. As to the latter determination, the IRS appealed. While the appeal was pending, the Fifth Circuit held in a similar case that the valuation misstatement penalty does not apply when the partnership is disregarded as a sham.14 The U.S. Supreme Court granted certiorari to resolve a Circuit split on this issue.

Under Code §6226(f), a court in a partnership-level proceeding has jurisdiction to determine the applicability of a penalty that “relates to” an adjustment to a partnership item. Thus, the issue was whether the valuation misstatement penalty “relates to” the determination that the taxpayers’ partnerships were shams. In resolving the dispute, the Court examined the structure of TEFRA and concluded that, while penalties must be imposed at the partner level, their applicability may be determined at the partnership level. In other words, a penalty can “relate to” a partnership-item adjustment even if the penalty cannot be imposed

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without additional, partner-level determinations.15 Next, the Court considered the applicability of the valuation misstatement penalty. Generally, a 20% penalty applies to any underpayment of tax attributable to any substantial valuation misstatement. The penalty increases to 40%, however, when a taxpayer’s adjusted basis exceeds the correct amount by at least 400%.16 The Woods Court determined that because “the partnerships were deemed not to exist for tax purposes, no partner could legitimately claim an outside basis greater than zero.”17 Since the partners used an outside basis greater than zero to claim losses that caused the partners to underpay their taxes, the resulting underpayment is “attributable” to the inflated adjusted basis amount. Thus, the Court held that (i) the District Court had jurisdiction in the partnershiplevel proceeding to determine the applicability of the valuation misstatement penalty, and (ii) the penalty is applicable to tax underpayments resulting from the partners’ participation in the tax shelter.

TAKEAWAYS While the case law made no mention of the attorneys’ roles or liability in any of the three fact patterns (other than to point out that the tax shelter in Woods was developed by the “now-defunct” law firm Jenkens & Gilchrist, P.C.), it goes without saying that, as professionals, we should steer clear of any involvement with abusive tax shelters.18 Model Rule of Professional Conduct Rule 1.16 instructs that attorneys should avoid counseling clients on matters involving illegal conduct or transactions. Attorneys representing clients in connection with abusive tax shelters risk stiff penalties as well as expensive and time-consuming malpractice litigation.

When Jenkens & Gilchrist closed its doors following its role in the marketing and promotion of fraudulent tax shelters, the IRS announced, “this should be a lesson to all tax professionals that they must not aid or abet tax evasion by clients or promote potentially abusive or illegal tax shelters, or ignore their responsibilities to register or disclose tax shelters.”19 Thus, attorneys representing partnership clients should consider whether a client’s proposed or existing structure has economic substance, and counsel clients regarding the lengthy audit proceedings and potential for penalties should the IRS suspect the partnership is merely a sham

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formed with the purpose of evading federal taxes.

ENDNOTES 1 See U.S. v. Woods, 134 S.Ct. 557(2013); Logan Trust & Tigers Eye Trading, LLC v. Comm’r, No. 12-1148 (D.C. Cir. 2015); Petaluma FX Partners, LLC v. Comm’r, No. 12-1364 (D.C. Cir. 2015); Basr Partnership v. U.S., No. 2014-5037 (Fed. Cir. 2015) 2 26 U.S.C. §§6221, et seq.

3 Note that all references in this article to a “partnership” include any LLC taxed as a partnership, and all references to a “partner” include a member of an LLC that is taxed as a partnership.

4 When preparing an LLC operating agreement in Business Docx, you will be prompted to select a tax matters member. You have the option to either name a specific member in the Operating Agreement, or indicate that the manager will appoint a tax matters member at a later time.

5 26 U.S.C. §6226(a) 6 Id. §6226(f) 7 Id. §§6230(a)(1)-(2), (c), 6231(a)(6) 8

134 S.Ct. 557 (2013)

9 Logan Trust & Tigers Eye Trading, LLC v. Comm’r, No. 12-1148 (D.C. Cir. 2015) 10 Petaluma FX Partners, LLC v. Comm’r, No. 12-1364 (D.C. Cir. 2015) 11 Both Tigers Eye Trading and Petaluma involved taxpayers holding interests in LLCs taxed as partnerships. Each such partnership was created to establish a Son of BOSS tax shelter pursuant to which each taxpayer artificially inflated his basis resulting in substantial “losses” that the taxpayers were able to use to offset against income and gains on their personal tax returns. The scheme artificially reduced their taxable income, as discovered by the IRS upon audit. Both cases were held in abeyance pending the Supreme Court’s decision in Woods, as the issue in all three cases was the same: whether courts in partnership-level proceedings have jurisdiction to determine the applicability of accuracy-related penalties related to the partners’ underpayment of income tax. Both cases were ultimately decided on June 26, 2015, consistent with the Woods’ holding.

12 Tax basis is generally the cost of an asset and it is used to determine the owner’s gain or loss for tax purposes upon sale.

13 Id. at 562 14 See Bemont Invs., LLC v. U.S., 679 F.3d 339, 347-48 (2012) 15 Id. at 564 16 Id. at 565; Code §6662(h) 17 Woods, at 565-66 18 For another recent case involving a partnership tax shelter and describing the attorneys’ role in marketing the scheme, please see Basr Partnership v. U.S., No. 2014-5037 (Fed. Cir. 2015).

19 See I.R.S. News Release IR-2007-71 (Mar. 29, 2007); Soled, Jay A. “Tax Shelter Malpractice Cases and their Implications for Tax Compliance,” American University Law Review 58, no. 2 (December 2008).

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Climbing the Tax-Efficiency Pyramid to Lower Taxes TIM VOORHEES, JD, WEALTHCOUNSEL MEMBER SINCE 2013 Opportunities for attorneys increased dramatically in early 2013 when the President signed the American Tax Relief Act of 2012 into law. While the demand for estate planning shrank when the estate and gift tax exemption increased from $1million per person to the new “permanent� exemption of more than $5 million per individual, the need for income tax planning grew substantially when the top marginal rates increased for most taxpayers. Many clients will now have top tax rates of more than 35 percent on capital gains and more than 50 percent on ordinary income unless financial planners provide solutions.

The impact of the new higher tax rates is evident when projecting retirement savings growth over 20 years. For example, a business owner funding a retirement plan with $500,000 over the next few years can expect the plan to generate more than $1,760,000 of tax-free PAGE

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income (if money grows at 6.5 percent and there are no taxes on contributions or withdrawals). If, however, the executive is married with income of more than $450,000, then marginal tax rates may be 39.6 percent at the federal level and 10.23 percent at the state level.

Together, these taxes reduce money going into Roth IRAs, retirement annuities, and related retirement investments by almost 50 percent.

If the executive keeps the money in annuities or stock investments, there will likely be additional taxes when the funds are withdrawn.

Even if withdrawals are taxed at capital gains rates instead of ordinary income rates, the Federal capital gains rate of 20 percent is often increased by the 3.8 percent surtax for couples earning more than $250,000, and further increased by state tax rates that approach or exceed 10% in major states like California and New York.

It is therefore common to see capi-

tal gains taxes that consume more than one-third of gains. In the largest state (California), capital gains rates can exceed 38%.

To illustrate the impact of taxes, it is useful to look at how taxes reduce returns across time. Consider a client who has $500,000 of excess income (e.g., income not used for lifestyle expenses) this year or over the next few years.

If the 50 percent rate on contributions applies along with the 38 percent rate on withdrawals, the $500,000 is worth only $662,287 in 30 years. On the other hand, if the client invests the $500,000 in vehicles that generate current tax deductions and avoid taxes on investment income and distributions, the $500,000 can grow across 30 years to be worth more than $5,000,000. Would a client rather have a half million of extra taxable income grow to $662,000 or $5,000,000?

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9 NUMBER 3 / Q3 2015

The impact of taxes will vary depending on the timeframes and investment returns. The following table shows the power of tax-efficient investing with different assumptions: Impact of investing excess income tax-efficiently

Now

20 Years at 6.5%

30 Years at 8%

With Tax-Efficient Planning Tools

$500,00

$1,761,823

$5,031,328

If 50% of Excess Income is Lost Taxes Before Investing

$250,000

$880,911

$2,515,664

If Investment Returns are Reduced by 38% Taxes

$250,000

$580,265

$1,068,205

N/A

$359,764

$662,287

If 38% of Accumlated Value is Lost to Withdrawal Taxes

The above numbers illustrate the power of tax-deferred accumulation but, with some types of retirement investment vehicles, the illustrated values may be further reduced by taxes on accumulation. Also, the tax rates on contributions and withdrawals may vary significantly depending on the timing of cash flows, changing tax rates, and other variables not considered on the above illustration.

Obviously, investments will perform better if there are no taxes on the contributions, accumulation, and withdrawals. Fortunately, American tax policy encourages the pre-tax funding of investments using a variety of planning instruments discussed on the following pages. Moreover, taw laws allow for the integration of legal, investment, and insurance tools to facilitate tax-free accumulation and distributions. As long as clients are willing to make longer-term investments and properly integrate planning instruments, they can climb a pyramid with each higher level allowing for bigger tax deductions in the current taxfree, more tax-efficient investment compounding, and larger tax-free income payments during years when funds are withdrawn.

Sorting through the different tax planning options may seem like a herculean task; however, the pyramid diagram simplifies the decision process. The six levels of the pyramid graphic, explained below, illustrate how clients are rewarded for advancing from traditional to more sophisticated strategies.

•

Level 1: The bottom level on the pyramid depicts how most clients receive their income. Their paychecks show heavy FICA, FUTA, SUTA, and other payroll taxes as well as withholdings for state and federal taxes. As indicated on many paystubs, more than half of the income can be lost to taxes

at Level 1. Moreover, after-tax investments in retirement vehicles can trigger additional taxes, as indicated on the right side of the pyramid below and in the after-tax numbers on the above table.

•

Level 2: Climbing the pyramid to Level 2 affords clients opportunities to invest in ERISA qualified plans. Such plans include 401(k) plans as well 403(b)s, SIMPLE plans, profit-sharing plans and defined benefit plans. While employee deferrals used to fund qualified plans will still be subject to payroll taxes, the heavy state and federal income taxes are deferred until money comes out of the qualified plans. The tax-deferred growth in retirement plans has helped Americans accumulate more almost $25 trillion in retirement plan assets.

Without advanced planning, this $25 trillion is all subject to ordinary income taxes during retirement or at death.

•

Level 3: Business owners and highly compensated employees often want more tax benefits than qualified plans afford. Too often, the top-heavy rules limit the amount of contributions by highly compensated executives. To work around the ERISA restrictions, financial planners offer a variety of non-qualified deferred compensation plans.

These include traditional deferred compensation plans involving salary and bonus deferrals as well

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as more sophisticated plans covered by 409(A) rules on deferred compensation. With the common Supplemental Employee Retirement Plan (“SERP”) arrangements, the employer must wait to receive the deduction until the employee receives the benefit.

Since 2004, the 409(A) regulations have increased the risk of current taxes applying to nonqualified deferred compensation plans, including restricted stock, phantom stock and performance

share plans, as well as stock appreciation rights and long-term bonus or commission programs.

Many executives have used these plans to accumulate substantial balances without realizing the full extent of the likely withdrawal taxes. Now these executives face much higher than expected taxes on their withdrawals because of the higher marginal rates in 2015. This is spurring growing interest in Levels 4 through 6 of the pyramid.

•

Level 4: The Level 4 solutions include a vari-

CLIMBING THE PYRAMID ENHANCES TAX-EFFICIENCY TAXES ON CONTRIBUTIONS

TAXES ON EMPLOYEE WITHDRAWAL LEVEL 6 Advanced Tax-Efficient Lifetime Income Solutions

Minimal Tax on Contributions

ChESOP Capital Split Dollar Charitable LLC Captive Preferred LLC Retirement Rescue

Minimal Withdrawal Taxes

LEVEL 5 Specialized Plans with Tax-Efficient Funding and Tax Free Moderate Tax on Contributions

Moderate Tax on Contributions

Withdrawals Super CLAT Section 79 Plan Section 162 Plan

LEVEL 4 Speicialized Plans with Pre-Tax Funding Partially Withdrawals Charitable Reminder Trust Gift Annuities Pooled Income Fund

Moderate Withdrawal Taxes

Moderate Withdrawal Taxes

LEVEL 3 Non-Qualified Deferred Comp Moderate Tax on Contributions

SERPS 409(A) Plans Traditional Deferred Comp

Heavy Withdrawal Taxes

LEVEL 2 Qualified Plans Heavy FICA, FUTA, SUTA Taxes

Heavy FICA, FUTA, SUTA Taxes

Profit Sharing Defined Benefit 401(K)

LEVEL 1 Traditional Compensation Heavily taxed with payroll taxes going in and ordinary income out

THE TAX EFFICIENCY PYRAMID PAGE

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Heavy Withdrawal Taxes

Heavy Withdrawal Taxes

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ety of charitable planning instruments that allow for large income tax deductions when they are funded as well as tax-deferred growth on the plan balances. Moreover, the distributions may have only moderate withdrawal taxes. For example, charitable remainder trusts (CRTs) can distribute tax-free or capital gains income.

Gift annuities can pay out partially tax-free income by returning the initial investment capital as part of each payment. These charitable tools can be custom-designed for each individual to start retirement income when income is most needed or tax rates are lowest. For these reasons, the charitable tools at Level 4 can provide better bottom line benefits than those generated at levels 1-3.

•

•

Level 5: Clients focused on retirement security and income may reject level 4 solutions because “charity begins at home.” Fortunately, there are charitable solutions, such as a Super CLAT designed with the current low 7520 rate that can increase what goes to the donor throughout retirement.

For substantial benefits from non-charitable tools, employers will often take deductions for a Section 162 plan or a Section 79 plan. For example, a company can make pre-tax contributions of $500,000 to a Section 79 plan so that an employee can receive tax-free income of nearly $1.1 million while also funding a tax-free death benefit for his or her heirs that may be more than $1 million.

Level 6: Creative planners continue to find synergistic combinations of planning instruments that can provide benefits that exceed those illustrated in Level 5. For example, the Family Retirement Account™ (“FRA”) leverages the benefits of universal life insurance using loans and a dynasty trust in order to convert taxable retirement income into tax-free cash flow and/or wealth transfers. Capital Split Dollar (“CSD”) helps employers take income tax deductions for funding tax-free retirement and death benefits for key executives. An Em-

9 NUMBER 3 / Q3 2015

ployee Stock Ownership Plan (“ESOP”) can provide tax-free build-up of assets. When the ESOP is combined with a charitable trust, the resulting “ChESOP” can produce both tax deductions in the early years and tax-free income in later years.

For clients with more charitable intent, a popular Level 6 strategy is the charitable LLC. $500,000 contributed can produce more than $2 million for family and charity. The family benefits can exceed those of the Section 79 plan while also giving clients the satisfaction of redirecting tax money to their favorite charities.

While qualified attorneys opine that the above Level 6 strategies are within the letter and spirit of the tax code, the techniques may be too complicated for some clients. Moreover, attorneys must consider a long list of legal, tax, and financial issues when integrating the components of the advanced planning tools. Failure to implement and monitor strategies correctly can create unnecessary audit risks. If the client has concerns about the ability of his or her team to maintain a Level 6 strategy across time, then simpler strategies at Levels 2 to 5 may be better.

CONCLUSION New tax laws, such as the 409(A) rules passed several years ago and the American Tax Relief Act signed in 2013, have curtailed many popular planning strategies. Wise planners, like Hercules, find that each time a head is cut off the hydra, two new heads grow. The decline in the demand for estate tax planning is small compared to the big increase in the demand for income planning and retirement planning. Attorneys have immense opportunities to serve the tens of millions of present and prospective clients who are stuck at Level 1 or Level 2 of the tax efficiency pyramid. As indicated above, there are compelling reasons and great financial rewards for the clients who advance to Levels 3, 4, 5 and 6 in the tax efficient lifetime income planning process.

ABOUT THE AUTHOR Tim is the Principal Partner at Matsen Voorhees Mintz, LLP and President of Voorhees Family Office Services.

He has 37 year of experience providing wealth, estate, and charitable planning for multi-million dollar estates through national wealth planning organizations and financial service companies. Tim regularly publishes articles in leading publications and speaks at conferences for many national organizations.

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Before you pour…

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9 NUMBER 3 / Q3 2015

A FEW TAX CONSIDERATIONS WHEN DECANTING MATTHEW T. MCCLINTOCK, JD, VICE PRESIDENT, WEALTHCOUNSEL EDUCATION

The uncertainty of the transfer tax system in place before ATRA1 motivated many clients to establish various irrevocable trusts as part of their estate planning process. In addition to the ILITs, IDGTs, and other irrevocable trust-driven lifetime wealth transfer strategies that wealthier clients implemented, most married couples who completed their planning before 2013 relied on mandatory marital deduction funding methods in their wills and revocable trusts.

Those common marital deduction strategies often forced the establishment of a bypass or “credit shelter” trust to set assets aside for the surviving spouse and other beneficiaries in an estate tax-sheltered environment. When the surviving spouse later died, the assets in that bypass trust would be excluded from his or her gross estate, passing to the remainder beneficiaries free of transfer tax.

But higher marginal income tax rates, a higher capital gains tax rate, and certain income surtaxes that washed in with the Affordable Care Act have put income tax-driven strategies closer to the top of the list for most clients. Moreover, while the pain of transfer tax was on a distant horizon, the pain of income tax is acute and immediate as clients see that their income and wealth doesn’t stretch as far as it used to. With trusts reaching the highest 39.6% marginal income tax bracket with only $12,300 in income (for the 2015 tax year), finding ways to minimize the amount of income trapped inside trusts and maximizing basis adjustment on appreciated assets have become among the most critical planning issues attorneys must consider when planning and administering clients’ estates.

IMPACT OF SHIFTED FOCUS ON CLIENT With ATRA came the combination of permanent, $5 PLANNING INCOME TAX million inflation-indexing estate tax exemptions and DSUE Amount portability for surviving spouses, obviating estate tax-driven strategies for all but a miniscule percentage of the U.S. population. In fact, according to a 2015 report from the Congressional Joint Committee on Taxation, only 0.2% (roughly two in 1,000) of Americans will die owing federal estate tax liability.2

The shifted focus from transfer tax to income tax can be particularly vexing in the context of a client’s existing irrevocable trust strategy. Whether the trusts were initially designed as irrevocable, or whether the trust has become irrevocable because of the settlor’s death, when circumstances change that impose new adverse consequences, or when new opportunities PAGE

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emerge that can benefit the client and her family, clients and their advisors need solutions to restructure irrevocable trusts for maximum benefit.

For many grantors, opportunities to modify a trust to trigger estate inclusion will mean a step up in basis when the grantor dies, allowing unrecognized capital gains to get wiped away as remainder beneficiaries receive a new basis under IRC §1014. For nongrantor beneficiaries of irrevocable trusts, modifications might strategically add general powers of appointment over trust corpus, allowing the value of those assets to be included in the beneficiary’s estate at death, again triggering a basis adjustment.

In other circumstances, modifications may be necessary to allow a trustee to update key administrative provisions to account for revisions to the governing trust code, or to change the situs and governing law of the trust to a jurisdiction with more favorable trust and tax laws.

Modifications might also allow the trustee to strategically allocate capital gains to income, or modify the trustee’s discretion in making distributions that carry PAGE

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out the trust’s Distributable Net Income to shift income trapped in the trust to beneficiaries in lower tax brackets. Trust modifications may also allow adjustments to grantor trust provisions, expanding, contracting, or shifting the identity of the taxpayer to strategically direct the trust’s income tax liability.

ASSET PROTECTION To paraphrase the cynic: so long as there are lawyers, there will be litigants. While many lawsuits are meritorious, others may stem from dubious claims, are brought as nuisance actions, or arise from simple malice by aggrieved parties.

Recognizing that many professions carry a higher level of litigation risk than others, clients often express concern about asset protection opportunities to strengthen their bargaining position in contested matters and improve the possibility for reasonable settlements with claimants.

Clients often turn to trust & estate and business attorneys to design and implement a series of strate-

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gies that mitigate exposure from creditors. But what happens when clients are beneficiaries of existing irrevocable trusts established by someone else, or when they have preexisting irrevocable trusts in place that offer suboptimal protection? Steps may be taken through trust modification techniques to change an existing irrevocable trust strategy for the better interests of the client.

For instance, in some jurisdictions a trustee may decant trusts that contain distribution or demand rights at certain ages into longer term discretionary trusts.

Also, modification may allow a trust subject to an “ascertainable standard”3 to be converted to a purely discretionary trust served by an independent trustee.

Many practitioners agree that converting the trustee’s power to a standard that is not “ascertainable” will better insulate the beneficiary’s interest in the trust, so long as the trustee is not related or subordinate4 to the beneficiary or the grantor.

Modifications may be desirable to change the structure of trust management, such as adding one or more specialized trustees, changing the mechanisms for reviewing, removing, and replacing trustees, or changing the trust’s situs and governing law to a more favorable jurisdiction – such as a state that has more liberal decanting rules, lower (or no) state income tax, superior asset protection laws, more favorable trustee investment powers, etc.

And some strategies rely on a third party modification from the outset. For many years the Wealth Docx Standalone Retirement Trust (SRT) assembly has incorporated an option to allow an independent party serving as a trust protector to convert any trust share originally established as a conduit share into an accumulation trust share, affording superior asset protection for beneficiaries receiving distributions under retirement accounts payable to the trust.5 Similarly, the “hybrid” DAPT strategy6 allows an independent trust protector to add the grantor as a discretionary beneficiary under a third party DAPT the grantor establishes for other beneficiaries. The trust is arguably not a self-settled spendthrift trust at inception, but if the trust protector decides – presumably independently – to add the grantor into the trust as a beneficiary, proponents of the strategy believe that the trust corpus will be insulated from claims by the grantor’s creditors.

9 NUMBER 3 / Q3 2015

DECANTING AS A MODIFICATION OPTION Trust decanting ranks fairly high on the spectrum of trust modification options, and it’s the first level that affords real creativity and flexibility.7 Much has been written on the subject and states are increasingly enacting decanting statutes. But few attorneys (let alone other professionals) have a firm understanding of the range of decanting options that exist, the mechanics of making it work, and the tax implications of decanting.

Trust decanting occurs when the trustee of an existing irrevocable trust8 (often referred to as the “originating” or “inception” trust) exercises his or her discretion in making distributions for the benefit of a beneficiary and, rather than distribute the property from the trust outright, the trustee distributes property in further trust (the “new” trust).

The origins of decanting stem from the position that if the trustee may distribute property outright – as 1L property class taught us, in “fee simple absolute” – to a beneficiary, then the trustee may distribute property in less than fee simple, by creating a new trust to manage the distributed property for the benefit of the beneficiary of the property. The trustee’s power to decant may arise from a state’s case law, from statute, or within the governing trust instrument.

TAX IMPLICATIONS OF DECANTING The IRS has not provided much guidance on the tax implications of decanting beyond highlighting a series of decanting-related issues that may trigger tax liability.9 One of the most important tax-related issues to resolve is the nature and identity of the decanted trust for tax purposes. Wrapped inside that issue are many other questions. Limited space and knowledge does not permit us to address them all, but consideration of a few is worth our efforts here.

FOR EXAMPLE… Is the new trust a new taxpayer, or is it an extension of the originating trust for income tax purposes?

We get some insight from the Treasury Regs, which indicate that, “If a trust makes a gratuitous transfer of property to another trust, the grantor of the trans-

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feror trust generally will be treated as the grantor of the transferee trust.”10 There is an exception where the transfer is directed by an individual who holds a general power of appointment over the property in the trust and that person directs the transfer. In that case, the individual exercising the power is treated as the transferor.11 In most trust decantings, the trustee exercising the power to decant will not have a general power of appointment over the trust. An even safer option is to require that any decanting be performed by an independent trustee who has no beneficial interest in the trust at all.12

causing the recognition of capital gains or losses on the assets, capital gains tax would be due and the basis of the assets in the trust would be subject to adjustment at the time of transfer.17

Assuming that the identity of the grantor for income tax purposes remains the same before and after the decanting, it seems logical that the taxpayer identification number (EIN) of the new trust is the same as that of the originating trust. While we don’t have clear guidance from the IRS on this point, PLRs suggest that this is the case.13 In the case of cascading subtrusts for individual beneficiaries after the death of the maker of an RLT, each subtrust would receive its own EIN at the time of funding. If the trustee later decants a subtrust into its own separate trust agreement, the new trust becomes an extension of that subtrust, and should receive the EIN obtained when the subtrust was established during administration.

But where the nature of the beneficial interests administered under an agreement are not materially different before and after a modification, Cottage Savings does not appear to apply and the decanting action should be a “non-recognition” event. Although the IRS is not yet providing public guidance on this issue, there are PLRs that help frame this position.20

To what extent do decanting transfers carry out DNI? Generally, any distribution from a trust carries out Distributable Net Income (DNI) to the extent of the lesser of the amount distributed or the amount of trust taxable income for the year of distribution.14 Further, we know that trusts that are created under a decedent’s will (or will substitute, like an RLT) are considered for income tax purposes as a beneficiary of the decedent’s estate.15 And assuming that the originating trust and the new trust are treated as the same taxpayer, the distribution of all the corpus should carry out all the tax attributes from the old trust into the new trust. As other authors point out, even the distribution of less than the entire trust corpus – a partial decanting in further trust – should be treated as distribution to beneficiary, carrying out DNI subject to a few limitations.16

In considering this issue, many turn to the holding of Cottage Savings18 for guidance. There the U.S. Supreme Court found that where there were material differences in the value and composition of assets that were exchanged in an asset swap, the taxpayers would recognize taxable gain or loss on the asset swap even if the assets were not distributed and the parties’ economic position hadn’t changed.19

Does a beneficiary who consents – or acquiesces – to decanting make a taxable gift?

If the beneficiary affirmatively consents to a decanting, can the beneficiary be treated as a transferor for transfer tax (gift, estate, and GSTT) purposes?

Although the Treasury’s position is unclear, we can make some reasonable conclusions to these and other questions. And to provide the lawyer’s answer, sometimes it depends on the nature of the decanting.

A beneficiary’s failure to exercise a legally enforceable right that arises under state law may constitute a taxable transfer if that failure extinguishes some legal right of the beneficiary.21 Further, when a beneficiary has a vested, presently-exercisable right to property and that beneficiary affirmatively consents to the transfer of that interest to other beneficiaries, the beneficiary will likely be treated as having exercised a taxable power of appointment in favor of those other beneficiaries.22

Do transfers of assets from an originating trust trigger the recognition of gain or loss?

The safer approach is to permit the trustee to exercise a decanting power without beneficiary involvement at all. This is especially true when acts of decanting alter the nature of beneficial rights or dispositive provisions, or modify powers of appointment.

If the act of decanting triggers a recognition event

Moreover, if the power to decant is indeed a power of

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the trustee, the trustee should be permitted to exercise that power subject to the trustee’s fiduciary obligations. A beneficiary should be required to show that the act of decanting constituted a breach of the trustee’s fiduciary duties in order to object to or set aside the decanting transfer.

Does an interested trustee who decants make a taxable gift?

When the trustee has no interest in the trust, we believe that the trustee who decants in furtherance of his or her fiduciary duties has no transfer tax concerns. As stated in Treasury Reg. §25.2511-1(g)(1), “A transfer by a trustee of trust property in which he has no beneficial interest does not constitute a gift by the trustee…” Further, the Regs provide that even when the trustee does have an interest in the trust, if the trustee makes a transfer in furtherance of a fiduciary duty, and if that duty is limited by a fixed or ascertainable standard, then the trustee has not made a taxable transfer.23 Where the act of decanting is intended to strengthen the asset protection character of the trust to convert from an ascertainable standard trust to a discretionary standard trust (and where this is permitted by governing law), it is more effective to have an independent trustee effect the decanting. Where a beneficiary or other interested party is serving as trustee, that interested trustee may resign to make way for an independent trustee to perform the decanting. In the alternative, a special independent trustee may be appointed concurrently with the trustee (either under the terms of the document, as provided by Wealth Docx, or by petition and appointment by a court) to then exercise the power to decant the trust to a more protective structure.

Who is the grantor or transferor for gift, estate, and GSTT purposes?

Because decanting is an extension of an existing trust – and assuming that the decanting is performed by an independent trustee bound to fiduciary duties – there should be no change in transferor for transfer tax purposes. A trustee should only be at risk of being treated as a transferor where the trustee has a beneficial interest in the trust, or where the trustee exercises the decanting power in a manner that discharges a legal obligation of the trustee.24

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As discussed above, if a beneficiary affirmatively consents to a decanting or requests a decanting in a manner that shifts the beneficiary’s interest in the trust to another beneficiary, the beneficiary may be considered to have made a taxable transfer. To avoid this result, decantings should be carried out by independent trustees without affirmative consent by the beneficiaries.

Many other questions about the tax implications of decanting remain, but unfortunately the IRS’s lips are sealed. After a few years of accepting comments on the tax consequences of trust modification action, the IRS imposed a moratorium on new decanting PLRs25 and appears to continue studying the issue internally.

Until that bright day when Treasury fully colors in the lines for us, we should counsel trustees carefully and err on the conservative side when decanting unfavorable trusts.

ENDNOTES 1

The American Taxpayer Relief Act of 2012, Pub. L. 112-240

2 Joint Committee on Taxation, “History, Present Law, and Analysis of the Federal Wealth Transfer Tax System,” March 16, 2015. Available online at https://www.jct.gov/publications. html?func=startdown&id=4744 3 An “ascertainable standard” trust is one that permits or directs the trustee to pay income and/or principal to the beneficiary for the beneficiary’s health, education, maintenance, or support. When a power is fixed or ascertainable, possession of that power by an interested trustee does not constitute a general power of appointment for transfer tax purposes. (IRC §§2041(b)(1)(A), 2514(c)(1).)

Critics of this drafting approach believe that when the beneficiary’s interest is ascertainable, it gives rise to a property interest to which a creditor may attach a claim. Vesting purely discretionary distribution power (over both income and principal) in an independent trustee is often far more advantageous from an asset protection perspective.

4 The Regs explain that the term “related or subordinate party” means a nonadverse party – that is, a party who does not have a personal interest in the trust – who is the grantor’s spouse (if living with the grantor), the grantor’s parent, descendant, sibling, or employee, or the employee of a corporation in which the grantor has substantial voting control or where the grantor is an executive.

If a party is related or subordinate to the grantor as defined by the Regs, then the grantor must prove by a preponderance of the evidence that the individual is not subservient. Regs. §1.672(c)-1 5 This strategy, pioneered under PLR 200537044, is often inartfully described as a “toggle” provision. More appropriately it’s a one-time switch – a detonator of sorts. Once converted, the trust cannot be converted back to a conduit trust. Further, the protector must exercise the power to convert a conduit trust to an accumulation trust within 9 months of the decedent’s death: the deadline for

9 NUMBER 3 / Q3 2015

identifying the beneficiaries under a qualified plan as required by Reg. §1.401(a)(9)-4, Q&A 5(b)(3). Attorneys must also bear in mind that PLRs cannot be relied on as precedent by any party other than the party who obtained it in their case. IRC §6110(k)(3).

6 For more information on this strategy please see LISI Asset Protection Newsletter #200, “Steve Oshins & the Hybrid Domestic Asset Protection Trust,” available online at http://www.oshins.com/ images/Hybrid_DAPT.pdf, 7 Trust modification options fall into a spectrum ranging from reformation (on the low end of flexibility) to modification, equitable deviation, decanting, and modification by protector. This article focuses on the decanting option as it provides both a high level of flexibility and a high degree of legal acceptance among the states.

At the time of this writing at least 33 states authorize trust modification by beneficiaries and others without court involvement; 23 states have statutes authorizing decanting. A few other states allow decanting under the common law.

8 Remember that the trust may have been irrevocable from inception, or it may have become irrevocable after the settlor died. A very common trust for which decanting might make sense would be the bypass or credit shelter trust established after the death of a settlor.

When that bypass is no longer needed to shelter assets from estate tax inclusion, decanting may be a good option to trigger “defects” that will cause inclusion and a §1014 basis adjustment when the surviving spouse or other beneficiary dies.

9 See Internal Revenue Service Notice 2011-101 10 Regs. §1.671-2(e)(5) 11 Id. 12 This is the default approach under the Wealth Docx decanting option.

13 See PLRs 200607015 and 200736002 14 See IRC §§652, 663 15 See Regs. §1.643(c)-1 16 See Blattmachr, Horn, & Zeydel: Tax Effects of Decanting – Obtaining and Preserving the Benefits, Journal of Taxation (WG&L) Vol. 111, No. 5, Nov. 2009 at 293; Regs. §1.643(a)-3(e) exs. 8-9 17 See IRC §1001 18 Cottage Savings Ass’n v. Commissioner, 499 U.S. 554 (1991) 19 Id. at 567 20 See, e.g., PLR 200736002 (division of trust on pro rata basis did not trigger gain or loss) and PLR 201516020 (division and modification of trust will not trigger realization of income, gain, or loss).

For further reading on this topic, please see Jason Kleinman, Trust Decanting: A Sale Without Gain Realization, ABA Real Property, Probate, & Trust Journal Vol. 49, No. 3 (Winter 2015) 453, 455 21 See Rev. Rul. 81-264, 1981-2 CB 185 22 See PLR 9419007 23 Treas. Reg. §25.2511-1(g)(2) 24 Wealth Docx contains default safeguards to prevent this from occurring.

25 See Rev. Proc. 2015-3 §5.01 (14), (20), (21).

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TODAY’S INVESTMENTS IN

PAY DIVIDENDS IN THE FUTURE KATELYN GRIFFIN, DIRECTOR, WEALTHCOUNSEL MEMBER SERVICES

Today’s rapid rate of technological advance and shifting expectations leaves the world of customer service in constant flux. Instantaneous information has become both an expectation and the norm thanks in large part to smart phones and ubiquitous mobile devices. Virtually everything we need to know and want to share can be accomplished with the click of a button.

If you think this change doesn’t affect your law business, think again. Your clients are comparing the service they receive from you and your staff with every other customer service interaction they have. If you aren’t measuring up, chances are their loyalty is waning. Follow me on a journey to learn how you can benefit from customer loyalty and how to improve your customer service experience.

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LOYALTY MATTERS I often speak with solo and small firm practitioners who question their fees. Am I losing clients because of the price tag? Am I undervaluing my experience and product? Does this sound like you? While there is an obvious correlation between price and profit, consider for a moment that price isn’t where your competitive advantage exists. Perhaps your law business could be easily (and inexpensively) adapted to compete in another profitable area: customer loyalty.

Loyal customers aren’t focused on price alone. They understand the holistic value of what they’re receiving – product and service. Loyal customers believe this value outweighs the monetary obligation.

A loyal customer is confident an error is the exception, not the rule, because they have had multiple experiences with your practice. These customers are far more likely to overlook the “dropped ball.”

Loyal customers’ needs are satisfied. In other words, they aren’t likely to survey your competitors. Think of it like this: very few people search for take-out menus after indulging in Thanksgiving dinner. Your goal is to provide an experience worth indulging in… repeatedly.

Loyal customers are also more likely to refer you to their network. That means more clients for you and more opportunities to continue the customer loyalty (revenue generating) cycle.

Now that you understand the benefits, let’s discuss how to create a culture of loyalty.

LOYALTY TECHNIQUES Focus on the experience, not the product.

Greeting clients with a warm welcome is common sense to most. Something that I hear many service providers overlook is the customer’s exit. When a client is leaving your office, what is the lasting impression they will take with them throughout their day?

Work to craft an equally personable and thorough exit experience. Never make a client feel like you or your staff’s attention has already shifted to the next person in line before they are even out the door. If there are action items or there is another step, be sure the client is fully prepared for what lies ahead. Answer any questions they ask. If possible, address questions

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they might not realize they need to ask. Remember, they are not just looking to you for documents. They are looking to you for counseling and guidance.

Manage your client’s expectations.

If you have learned something new that will change the scope of your customer’s agreement, update them. Ensure they understand what has changed, any related implications, and why. Don’t save news that will affect their future or pocketbook for signing meetings or invoices. While it can be uncomfortable to share bad news, avoiding this pitfall will help you earn your customer’s trust.

Tailor communication to your niche audience and content.

High net worth families have different needs from a young entrepreneur or single mom. Baby Boomers have different preferences from a Gen X client. Determine what communication channels are most convenient and effective for your niche, and adjust accordingly. If being accessible over the phone will provide a more valuable experience for your customers, work to create this culture. This may mean locating outside services, revising job responsibilities, documenting processes or providing staff incentives.

Alternatively, if email is a preferred method of communication, dedicate time to provide timely responses.

Consider what you are communicating. Some news is best delivered in person. Other updates should be shared quickly through a phone call or email. Set communication expectations in your first meeting. Many firms include details and contact direction in their engagement letter, too.

Create a personalized phone greeting.

Too often generic greetings such as “law office” are utilized. Maximize this interaction with your customers and prospective customers. Be sure your receptionist or answering service speaks from a script that identifies your law office by name. Even if you are a solo practitioner who uses a cell phone to conduct client calls, your greeting should be professional and specific to you. The same applies to voicemail greetings. When possible, opt for people over machines.

Human interaction yields a better experience than automated systems. Your goal is to distinguish yourself PAGE

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from the first interaction to the last.

Streamline your call transfer process.

Have you ever called a service provider for support and end up repeating your question multiple times to different people? Don’t create that experience for your customers! Sometimes multiple team members will need to interact with customers. If that is the case, create workflows, processes or scripts that ensure staff is limiting redundancies for your clients.

Try to minimize call transfers and eliminate cold or blind transfers. Anyone speaking with customers should be trained to capture the customer’s name, return phone number and reason for the call. If a transfer must occur, staff should ensure that their colleague is ready and able to accept the call, knows the customer they will be speaking with and why they are calling.

This approach will save the customer time while helping to resolve their need quickly.

Fine-tune your conflict resolution strategy.

Human error, redundancies, inefficiencies, and silly oversights are bound to happen at some point. When they do, there are clear strategies for resolving customer conflicts that can hedge customer disloyalty.

The most obvious and important component of conflict resolution is listening. Allow the frustrated client to express their dissatisfaction as much as necessary

Loyalty Techniques • Focus on the experience, not the product.

• Manage your client’s expectations.

• Tailor communication to your niche audience and content.

• Create a personalized phone greeting.

• Streamline your call transfer process.

• Fine-tune strategy.

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your

conflict

resolution

before you respond. When you do respond, accept responsibility. Don’t make excuses. Your customer isn’t paying you for excuses. Apologize for the experience sincerely. This isn’t a time to “litigate”; defensiveness will only push the situation further away from resolution. By accepting responsibility for the error and experience your customer is more likely to feel heard.

Once you have been able to defuse emotions and identify the issue, ask questions to understand what will satisfy your customer. Present solutions and agree on a direction. Assure your customer that you are their advocate. Once a resolution is agreed to, move on.

LOYALTY PAYS Customer service is the art of ensuring satisfaction with a service or product. For your law business, customer service comes in multiple forms. It is not limited to executing optimal planning strategies in well-crafted documents. Providing exceptional service is about the time you spend as a counselor. It is about the guidance you share to reassure your customer is in good hands. Customer satisfaction comes from purposeful, architected interactions with you and your staff. Enhancements in the experience your customers receive provides you a much greater opportunity to satisfy needs, which in turn creates loyal customers. Investments made today to create a culture of customer loyalty will pay dividends in your practice for years to come.

ABOUT THE AUTHOR As Director of Member Services & Community, Katelyn Griffin is responsible for ensuring that each WealthCounsel member enjoys an elite experience. Her mission is arm each member with the tools, resources and knowledge needed to grow profitable and sustainable practices while adapting to the evolving needs of their clients. Katelyn has a decade of experience in operations and customer service throughout the financial services, accounting and SaaS industries.

When Katelyn joined WealthCounsel in February 2013, she brought with her a unique perspective of internal dynamics within professional service firms ranging from boutique start-ups to mid-size regional corporations. She obtained her B.S. degree in Business Administration - Marketing at the University of Central Florida.

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Getting Appreciated Real Estate Out of C Corporations (Part II) JERAMIE J. FORTENBERRY, JD, LLM, WEALTHCOUNSEL EXECUTIVE EDITOR As discussed in the first part of this series, C corporations are tax-inefficient forms of business. C corporation income is taxed twice—once when it is earned, and again when it is distributed to the shareholders.

To avoid this double taxation, most newly formed businesses use pass-through entities like S corporations or limited liability companies (LLCs) to own real estate. But a few decades ago, S corporation requirements were more onerous and LLCs didn’t exist. Because of this, and for other reasons, many C corporations still own real estate.

Part I of this series discussed two strategies to get real estate out of a C corporation: (1) distributions to shareholders and (2) sales to shareholders or other third parties. This article discusses the use of conversions to move appreciated real estate from C corporations into more tax-efficient business structures.

A conversion changes the tax classification of the C corporation to either an S corporation or to an LLC. This can avoid double taxation of future appreciation in value and, in the case of subchapter S elections, may avoid double taxation altogether.

CONVERTING A C CORPORATION TO A SUBCHAPTER S CORPORATION The least expensive way to convert a C corporation to a pass-through entity is to make a subchapter S election. A subchapter S election can be made without changing the corporation’s form. The shareholders simply file Form 2553 (Election by a Small Business Corporation) by the 15th day of the 3rd month of the corporation’s current tax year. Once the election is filed, the former C corporation becomes a subchapter S corporation and—with the exceptions discussed below for passive income and built-in gains—does not pay an entity-level tax. This allows the corporation to avoid a corporate-level tax on earned income or gain from the sale of its assets. All of the corporation’s income is reported by the shareholders on their perPAGE

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sonal income tax returns.

Not all corporations qualify to elect subchapter S status. In order to qualify as an S corporation, the business entity must meet several requirements: Situs Requirement – Subchapter S status is only available to entities that are taxes as United States corporations; foreign corporations are ineligible to make a subchapter S election.

Capitalization Requirement – The corporation must not have more than one class of stock. Although differences in voting rights are disregarded, there can be no economic differences like dividend or capitalreturn preferences.

Passive Income Requirements – If the corporation has pre-conversion earnings and profits, excess passive income is taxable to the corporation and thus subject to double taxation. If an S corporation is taxed for excess net passive income for three consecutive years, the Internal Revenue Service will automatically terminate its subchapter S status.

Shareholder Requirements – The corporation must have no more than 100 shareholders, and each shareholder must be either a U.S. citizen or resident. Some estates, trusts, and tax-exempt organizations may also be shareholders.

Whether a subchapter S election will completely avoid double taxation of real estate often depends on how long the corporation holds the real estate. Businesses that convert from C corporation to S corporation status are potentially subject to built-in gains tax if the property is sold during a ten-year period.1 Upon a sale of the property during the built-in gains period, an entity-level tax is levied on the excess of the fair market value of the corporation’s assets over their basis at the time of conversion. This built-in gains tax applies to any appreciation that occurred prior to the conversion. If the corporation can hold on to the 1 I.R.C. § 1274.

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appreciated real estate for a 10-year period, it may completely avoid double taxation on the sale of the property.

Even if the client plans to sell the real estate within 10 years (or doesn’t know when the real estate will be sold), the immediate benefit of eliminating the double taxation of current earnings is often reason enough to file a subchapter S election. If the corporation meets the requirements for subchapter S status, there is often no downside to filing the election.

CONVERTING A C CORPORATION TO LIMITED LIABILITY COMPANY As stated above, some entities are not eligible to file a subchapter S election. If the corporation does not meet the eligibility requirements for electing subchapter S status, it may be converted to an LLC. Unlike a subchapter S election, though, a conversion from C corporation to LLC has immediate income tax consequences that must be carefully evaluated. Still, if taxes cannot be fully avoided on a transfer of real estate, the second-best alternative is to minimize them. Depending on the circumstances, long-term savings resulting from conversion to an LLC may justify the up-front tax cost.

As mentioned above, a subchapter S conversion can be accomplished without a change to the corporate form. Conversion to an LLC is more complex. There are four ways to convert a C corporation to an LLC:

9 NUMBER 3 / Q3 2015

Assets-Up Conversion – The corporation makes a liquidating distribution of assets to its shareholders. The shareholders then contribute the assets as a capital contribution to the LLC. Assets-Over Conversion – The corporation transfers its assets to the LLC in exchange for interests in the LLC. The corporation then transfers the LLC interests to the shareholders in liquidation.

Interest-Over Conversion – The shareholders transfer the shares of the corporation to an LLC, which becomes the sole shareholder of the corporation. After the transfer of stock to the LLC, the corporation liquidates and distributes its assets to the LLC. State Law Merger or Statutory Conversion – The corporation merges into or elects to become an LLC under provisions of state law. (This option is only available in states with enabling legislation.)

No matter how the conversion is structured, the shareholders leave the transaction with LLC membership interests that they received in exchange for their stock in the former corporation. This exchange of stock for membership interests—whether direct or indirect—is generally taxable to both the shareholders and the corporation. This requires a careful comparison of the tax cost of the conversion and the tax cost of a future sale of the real estate in the absence of a conversion.

If the real estate has not appreciated substantially (or is currently distressed but expected to appreciate in the future), the future tax savings may outweigh the immediate tax cost of the LLC conversion.

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Alaska and Tennessee Community Property Trusts: UNDERSTANDING THESE BASIS ADJUSTMENT TOOLS AND THE UNCERTAINTY THEY CARRY PATRICK MURPHY, JD, LLM, WEALTHCOUNSEL MEMBER SINCE 2015 With the passage of the American Taxpayer Relief Act of 2012, the lifetime unified estate/gift tax exemption was “permanently” set at $5 million ($5.43 million adjusted for inflation in 2015). Although the estate tax does not pose a threat to most Americans, recent changes in tax law brought about by the passage of the Patient Protection and Affordable Care Act of 2010 and the American Taxpayer Relief Act of 2012 have made income tax planning – specifically with respect to capital gains – an issue to be brought to the forefront of any estate planning strategy, regardless of net worth.

In the context of estate planning, there are many practical reasons why one would need to sell an asset resulting in a capital gain. For example, the death of an officer or other key person in a family business may necessitate a sale of the business due to the lack of participation and knowledge once provided by the decedent. Also, the heirs or beneficiaries of a decePAGE

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dent may be contractually obligated under a buy/sell agreement to sell the business resulting in a capital gain. Additionally, market conditions may dictate the sale of assets inherited from a decedent in order to hedge against an expected market downturn. Finally, the general sale of assets inherited from a decedent may be necessary for liquidity purposes in order to

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replace lost earnings once provided by the decedent.

To understand how capital gains are calculated, we should first briefly explore the concept of basis. In short, cost basis is equal to the purchase price paid to acquire a capital asset, subject to certain upward and downward adjustments made for additional improvements and depreciation, respectively. When a capital asset is sold, the difference between the sales price

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(presumably, fair market value) and the cost basis (subject to adjustments) is treated as a capital gain or loss depending on whether the fair market value is greater than or less than the cost basis. The federal tax rate applied to capital gains varies depending on filing status and the applicable adjusted gross income bracket of the taxpayer.

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also impose a capital gains tax that must be applied to the federal rate. Any depreciation taken on the asset reduces the cost basis, resulting in additional tax liability to “recapture” and offset any previous depreciation deductions. The example below illustrates the effect that capital gains can have on the net proceeds received from a transaction and exemplifies why many individuals are reluctant to liquidate capital assets.

EXAMPLE 1: The following example assumes the taxpayer is a married couple filing jointly: ADJUSTED GROSS

2015 CAPITAL GAINS

INCOME

TAX RATE

$250,000 - $450,000

15%

Over $450,000

20%

RECAPTURE TAX RATE

25%

NET INVESTMENT

3.8% (NII applies if adjusted gross income exceeds $250,000)

INCOME SURTAX RATE

Assume Stan and his wife Patrice own an apartment building in Arkansas that they purchased for $1,000,000 in 1975. The current fair market value of the property is $10,000,000. If they sell the property, they will have taxable gain of $10,000,000 assuming the property is fully depreciated. Of the $10,000,000 gain, $1,000,000 will be treated as depreciation recapture and taxed at federal recapture rates. They have more than $250,000 in other adjusted gross income meaning the net investment income surtax rates will also be applicable.

20% FEDERAL CAPITAL GAINS TAX (ON $9 MILLION)

$1,800,000

25% DEPRECIATION RECAPTURE TAX (ON $1 MILLION)

$250,000

3.8% NII SURTAX (ON $10 MILLION)

$380,000

7% ARKANSAS CAPITAL GAINS TAX (ON $10 MILLION)

$700,000

TOTAL TAXES INCURRED ON SALE

$3,130,000

As we see, capital gains taxes can have a detrimental impact on a potential sale of a capital asset. Thus, the basis the taxpayer has in property to be sold plays a vital role in determining to what extent capital gains PAGE

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tax will be incurred. Generally it is most desirable to have a basis that is as close as possible to, if not equal to, the fair market value of the property being sold.

Under the Internal Revenue Code (“IRC”) §1014(a)(1), property inherited from a decedent receives a basis equal to the fair market value of the property as of the date of the decedent’s death. This is commonly referred to as a “step-up” in basis if the asset has appreciated in value since the initial acquisition by the decedent. If the converse is true and assets have depreciated in value this is known as a “step-down” in basis.

THE COMMUNITY PROPERTY ADVANTAGE The portion of property to which the basis step-up is applicable depends on the jurisdiction. A majority of states in America have adopted the English common law concept of separate property. Under this regime, property acquired by a married individual will remain separate property unless agreed upon otherwise. A married couple could have property owned jointly in a separate property jurisdiction (usually as tenancy by the entirety). For purposes of the application of IRC §1014(a)(1), the surviving spouse would only receive a basis step-up on the decedent’s separate one-half interest. A subsequent sale of the property would reflect a basis equal to one-half of the fair market value of the property at the decedent’s death plus the current adjusted basis the surviving spouse had in the property, if any.

Nine states (Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington and Wisconsin) are community property jurisdictions. Two additional states, Alaska and Tennessee, allow individuals to opt in to those states’ elective community property regimes. The concept of community property is derived from French and Spanish law whereby property acquired by either spouse during a marriage vests a one-half interest in the property to each spouse as community property.

Under IRC §1014(b)(6), a special basis rule applies to community property states. Upon the death of the first spouse, the surviving spouse receives a basis step-up in both the decedent’s one-half interest in the community property as well as the surviving spouse’s one-half interest in the community property. A subse-

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quent sale of the property would reflect a basis equal to the fair market value of the entire property at the decedent’s death (as opposed to a basis step-up of only the decedent’s one-half interest of property as is the case in separate property states).

Assuming the asset is depreciable, not only does the step-up in basis eliminate or greatly reduce any capital gains tax liability, but it also allows the surviving spouse to generate additional depreciation deductions starting from the fair market value of the property as of the decedent’s date of death, thereby providing an additional offset of income from other sources.

The following example illustrates the financial benefit that §1014(b)(6) affords individuals owning property in community property jurisdictions versus those owning property in separate property states.

EXAMPLE 2: Stan and Patrice paid $1,000,000 for ABC stock, titled tenants by the entirety in a separate property jurisdiction. If Stan dies in 2015 and all of the stock is worth $2,500,000, Stan’s one-half interest gets a step-up in basis to $1,250,000.

Patrice’s basis in her one-half interest is still $500,000. If Patrice sells all of the ABC stock for $2,500,000, then her total basis is $1,750,000, resulting in a gain of $750,000. If, ignoring the 3.8% Net Investment Income Surtax and depreciation recapture, a 20% capital gains tax rate is assumed, Patrice has $150,000 in tax liability.

But if Stan and Patrice owned the ABC stock as community property, then when either spouse dies, the entire amount of the stock receives a step-up in basis to the fair market value, (i.e. $2,500,000). If the survivor sold the stock for $2,500,000, there would be no capital gain incurred.

Recognizing the income tax benefits of owning community property and the potential to generate revenues for the state, the legislatures of Alaska and Tennessee enacted laws allowing both residents and non-residents alike to opt in to a community property regime. The Alaska Community Property Act was

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passed in 1998 with Tennessee following in 2010. Under each statute, the law allows for the creation of a community property trust whereby residents and non-residents can take property located in separate property jurisdictions and convert that separate property into community property by transferring ownership to an Alaska or Tennessee community property trust.

•

Although the state statutes are not identical, the requirements of creating a community property trusts are generally as follows:

•

A declaration in the trust document that the trust is a community property trust;

•

At least one qualified trustee (which means a resident of Alaska or Tennessee or a qualified bank or trust company located in Alaska or Tennessee);

•

Signatures of both spouses; and

•

Specific “warning” language in capital letters to be inserted at the beginning of the trust document.

Community property trusts work well in conjunction with estate plans that have already been implemented. Assuming that a couple has already created separate or joint revocable trusts, appreciated property currently owned by the revocable trust or by the spouses individually would be transferred into a new community property trust. At the death of the first spouse, when the allowable basis adjustment occurs under §1014(b)(6), the community property would be divided. One-half of the property would be distributed according to the deceased spouse’s estate plan, and the other one-half would be distributed to the surviving spouse either outright or into a structure consistent with the survivor’s estate plan.

Importantly, community property trusts are not a “one-size-fits-all” solution. The ideal clients for community property trusts are married couples who are not residents of a community property state and who have one or more of the following characteristics: •

They are in a long-term, stable marriage;

•

One or both individuals own highly appreciated property, stocks, real estate or business interests;

•

Their financial portfolio is heavily weighted in one or two stocks which they are reluctant to liquidate because of exposure to capital gains tax;

•

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does not want to manage and will liquidate; and •

They are older individuals or at least one has a reduced life expectancy.

Despite the tremendous income tax benefits that community property trusts may offer, these structures carry several risks. In a community property regime, the personal creditors of a debtor spouse can levy and foreclose against the non-debtor spouse’s interest in community property. Conversely, in a separate property jurisdiction, property that is owned as tenancy by the entirety can be levied by the personal creditors of the debtor spouse but the creditor cannot foreclose on that interest to satisfy a judgment. In addition, the creditor’s claim is extinguished upon the death of the debtor spouse and the surviving spouse owns the property unencumbered and free of all liens.

Thus, converting separate property into community property can significantly reduce the creditor protection afforded through other forms of property ownership such as tenancy by the entirety.

Also, if the assets in the community property trust significantly depreciate in value, the desired tax savings disappear. If the fair market value of the asset as of the decedent’s date of death is less than the cost basis of the asset, the taxpayer will be in a worse position than they were in before transferring the property into the community property trust.

Finally, the Internal Revenue Service’s position concerning elective community property regimes with respect to tax basis has not been affirmatively established. Although the Alaska Community Property Act has been in effect since 1998, the Internal Revenue Service has not directly issued a position on the matter. In 1944, the United States Supreme Court in Commissioner v. Harmon held that an elective community property statute was ineffective to equalize income between spouses for income tax purposes.

In 1977, however, Revenue Ruling 77-359 concluded that the conversion of separate property to community property by residents of a community property state would be effective for gift tax purposes while ineffective for the transmutation of income from such property.

Although neither pronouncement is directly on point, there are arguments supporting both sides. Some practitioners expand the holding in Harmon to say that determining tax basis is an income tax related issue and thus Harmon should negate the income tax advantages stemming from the transmutation of separate property to community property under an elective community property regime. Others argue that Harmon was decided well before the enactment of §1014(b)(6) and thus shouldn’t be followed. Further, they cite Revenue Ruling 77-359 in which the IRS clearly recognizes that separate property can be converted into community property under state law which is the only technical requirement in §1014(b) (6) with respect to the nature of the property. The absence of definitive case law or a revenue ruling on point creates some risk for the practitioner that the nature of the transaction will not be respected and thus the tax advantages thwarted.

In conclusion, the current state of the law has made the capital gains tax the new “estate tax” that should be on everyone’s radar. It is well worth reviewing your client’s current estate plan for potential opportunities to add value. The Alaska or Tennessee community property trust is a powerful tool that can be leveraged to drastically reduce or eliminate the capital gains, provided the conditions are right. This said, community property trusts are not necessarily appropriate for all clients and do come with some inherent risks which must be weighed against the benefits.

ABOUT THE AUTHOR Patrick H. Murphy is an associate attorney at ILP + McChain Miller Nissman, an international estate planning law firm based in Little Rock, Arkansas and St Croix, USVI. Mr. Murphy graduated with an LL.M. in taxation from the Southern Methodist University Dedman School of Law in 2012. He advises clients with respect to a wide range of issues relating to wills and trusts, estate planning, trust administration, corporate and partnership matters, charitable giving, private foundations, supporting organizations, life insurance and taxation. In addition, Mr. Murphy counsels clients on matters relating to family owned businesses, including exit and succession planning, governance and control, and the significance of these issues to family relationships.

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The Importance of Basis.

THE NEW ERA OF ESTATE PLANNING JEREMIAH H. BARLOW, JD, TRUST & ESTATE FACULTY, WEALTHCOUNSEL EDUCATION

Understanding basis and how it applies in estate planning is one of the foundational concepts of the post-ATRA era. Prior to the enactment of the American Taxpayer Relief Act (ATRA) in 2013, the primary goal in estate planning was to leverage transfers in order to reduce the size of the estate

upon death, and minimize the effects of estate tax.

This included using bypass trusts or other similar mechanisms to reserve a deceased spouse’s unused estate tax exemption. This strategy was sound, as the aggregated federal and state transfer taxes were much greater than income tax rates.

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In stark contrast, today’s post-ATRA environment is one with increased income tax rates, and significantly higher federal transfer tax exemptions. This change represents a significant paradigm shift towards minimizing income tax. Due to this new tax landscape, the focus of estate planning has moved to income taxcentric strategies, most notably, leveraging the stepup in basis.

After providing a foundational understanding of basis, this article then outlines some key reasons why it is most beneficial to retain assets in a deceased individual’s estate to gain a step-up in basis for the inherited assets, and reduce income tax upon the sale of those assets.

WHAT IS BASIS? In its simplest form, basis is the cost to purchase the asset.1 For example, if you purchase stock, your basis is the purchase price, plus costs and transfer fees. Basis is important because upon the sale of an asset, capital gains tax liability is calculated based on the increase from the sale price and the basis. (Conversely, capital losses arise when the asset is sold for an amount less than its basis.)

In estate planning, perhaps more important than basis itself, is how it is treated upon transfer. The two important transfer of basis rules are 1) transfer of basis upon death (or “step-up” basis) and 2) transfer of basis during life (or “carry-over” basis).2 Here is a quick primer on how these two rules work: Step-up Basis: Pursuant to IRC §1014, property that transfers at death is stepped up to the fair market value of the property on the date of death. By way of example, if a stock was originally purchased by a decedent for $5, and upon the decedent’s death the stock is now worth $100, the basis is stepped up to $100. The result is that the recipient of that stock can now liquidate that stock at $100 with no capital gains tax liability.

Carry-over Basis: Under IRC §1015, if property is gifted from a donor to a donee, then the donee inherits the basis of the donor. For example, if stock that was purchased for $5 is gifted, then the donee’s basis is the same as the donor’s. In this case, five dollars.

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Importantly, a step-up in basis can only be achieved for assets that are in the gross estate of the decedent.3

FLEXIBILITY IS KING In today’s high income tax environment, taking advantage of a step-up in basis at death can be advantageous. In the past, we would create estate plans instructing that upon a surviving spouse’s later death, the assets would be distributed into a Survivor’s Trust and a Bypass Trust (and possibly a QTIP). Many trusts distributed the assets into these various trusts based on formulas that compared a couple’s estate value to the estate tax at the time of death. The result was more-or-less a blind distribution of assets into these trusts, without regard to the character of the asset or its basis.

Gone are the days of merely designing an estate plan to blindly funnel assets into a bypass trust upon a first spouse’s death, especially if there is no estate tax exposure.4 The assets placed in a bypass trust are not included in a surviving spouse’s estate and thus do not receive a step-up in basis once the surviving spouse dies. This can create a negative income tax effect if assets in the bypass trust substantially appreciated while in the trust, and the beneficiaries later wish to sell the appreciated assets upon the surviving spouse’s death. In short, the beneficiaries are stuck with carry-over basis of sorts. Basis would be adjusted when the first spouse dies, but would not be adjusted again when the survivor died because the assets “bypassed” that survivor’s estate.

Today, estate plans should be drafted to maximize flexibility to take advantage of the step-up in basis at a client’s death. Here are a couple options and considerations when planning for basis flexibility.

LEVERAGING GENERAL POWERS OF APPOINTMENT TO MAXIMIZE BASIS When used correctly, powers of appointment can be a strong tool for basis management.5 Carefully crafted powers of appointment can lend flexibility by allowing inclusion in the gross estate, and subsequently result in a step-up in basis.

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Granting an individual a general power of appointment is a frequently-used method to force estate tax inclusion without granting actual possession. Merely holding the power creates estate tax inclusion, regardless of whether it is acted upon. For example, if an individual exercises a testamentary general power of appointment, property subject to the power is considered to have passed from the decedent holding the power, and thus, the property will receive a step-up in basis for income tax purposes. Similarly, if an individual dies without exercising a testamentary general power of appointment, the property will also receive a step-up in basis because it is considered to have been acquired by the deceased power holder.6 Another option planners can leverage is a formulabased testamentary power of appointment. Drafting powers with a formula that absorbs the remainder of a beneficiary’s unused exclusion amount provides a step-up in basis to assets under the power, while sidestepping federal estate tax liability.

There are some issues to be aware of when using a general power of appointment. First, is how broad or narrow to draft the power of appointment. Powers of appointment are beneficial to the extent that the income tax saved by increasing tax basis exceeds the estate tax inclusion cost. Factors to consider in the tax formula: 1) ratio of the federal estate tax attributable to the general power of appointment, to the anticipated income tax savings if the property was included in the gross estate; 2) income tax rates (federal and state) at the time of sale; 3) depreciation rate in light of the trust’s depreciable property; and 4) assets receiving greatest benefit from the built-in gain.

Although beyond the scope of this article, there are additional drafting options to increase flexibility, such as utilizing a trust protector/advisor (to later trigger a general power of appointment), decanting PAGE

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(when an existing irrevocable trust does not have flexibility), as well as merely distributing the assets outright to a surviving spouse (so that the property is included in the surviving spouse’s estate). Each option has its own design hurdles, and should be closely examined when drafting an estate plan.

TAKING ADVANTAGE OF STEP-UP IN BASIS When implementing tax basis planning, you must differentiate assets by how they are affected by basis. For low-basis assets that benefit greatly from a step-up in basis (i.e. founders/creators of intellectual property, publicly traded companies, and real estate development) an effective plan would likely center on allowing the clients to “die with the asset” in order to gain a step-up in basis. The perfect scenario for such a plan is when a client’s estate does not exceed the estate tax exemption amount.

Conversely, for assets that are unlikely to benefit from a step-up in basis (discussed in more detail below), the goal is often to transfer assets out of the estate.

Removing high-basis assets from the estate is beneficial only to the extent that the cost benefit of transferring the assets out of the estate exceeds the federal and/or state transfer tax liability.

ASSET-BY-ASSET ANALYSIS We must now pay close attention to assets that provide maximum income tax benefits from a step-up in basis. A thorough knowledge allows for little or no realized gain upon sale, and/or preferential capital gain treatment. Highly appreciated assets, for example, benefit greatly from a step-up in basis, whereas cash

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(which always has a basis equal to its face value) provides no step-up benefit.

step-up.9 As a result, they are not beneficial from a basis standpoint.

The following key asset classes provide the greatest benefit from a step-up in basis:

CONCLUSION

•

highly appreciated property,

•

intellectual property,

•

mortgaged real estate (specifically, property with a mortgage that exceeds the basis),

•

low basis property, and

•

depreciated property.

Intellectual property is considered a non-capital asset while in the hands of the creator. However, once received through inheritance, intellectual property is characterized as a capital asset and receives a step up in basis.7 Asset classes providing little or no benefit from a step-up in basis include the following:

The passage of ATRA ushered in a new era of estate planning; one that focuses on retaining assets in the estate to gain a step-up in basis. Gone are the days where we concentrated primarily on testamentary transfers of assets out of the estate. Further, when funding trusts we need to analyze our clients’ estates on an asset-by-asset basis to ensure that each appropriate asset receives a step-up in basis.

RESOURCES: The New Estate Planning Frontier: Increasing Basis by Michael A. Yahus, JD, LLM and Carl. C. Radom, JD LLM Running the Basis and Catch Maximum Tax Savings, Part 1 (January 2015) and Part 2 (February 2015), Paul S. Lee, JD, LLM of Northern Trust.

•

Cash,

•

High basis property,

•

Assets valued at a loss, and

ENDNOTES

•

IRAs and other qualified plans

1 26 U.S. § 1012

Cash does not provide any benefit from a step-up in basis because its basis is always equal to its stated value. Importantly, assets valued at a loss will receive a step-down in basis.8 Basis adjustment at death would eliminate the loss for both ordinary income and capital assets. For mortgaged real estate, look for instances where the amount of the mortgage exceeds the property’s adjusted basis. This is called “negative basis” and “negative capital”. Gifting negative capital will trigger gain based on the amount that the mortgage exceeds the property’s adjusted basis. Lastly, IRAs and other qualified plans (as well as all forms of IRD) are not entitled to a

2 26 U.S. § 1014 and 26 U.S. § 1015 3 26 U.S. § 1014(b) 4 Notably, a bypass trust still has significant benefits and should still be used in many circumstances, such as when a client has over the state or federal estate tax exclusion amount.

5 Section 1014 (b) (1) and 2514(c) defines a general power of appointment as “power exercisable in favor of 1) the power holder, 2) his or her estate, 3) his or her creditors, or 4) creditors of his or her estate.

6 Treasury Regs § 2041 7 IRC § 1221(a)(3) 8 26 U.S. § 1014(b) 9 Per 1014(c), any asset that is income in respect of a decedent will not be eligible for a step-up in basis at death. This is why IRAs, annuities, and other similar qualified accounts do not receive a step up at death.

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To Multiscreen or Not? BLAIR JANIS, JD, DIRECTOR, WEALTHCOUNSEL TECHNOLOGY Several years ago I did a technology presentation with a federal judge from Utah. In the course of our preparation he told me that he has three monitors attached to his desktop computer, including two that are oriented in portrait mode instead of landscape (more on this in a moment). Based on my limited perspective at the time, I challenged the wisdom of his setup.

I’d always advocated for two monitors for a more productive technology experience … but three? That HAD to be overkill, right? After all, there is a law of diminishing returns, which often in the technology world becomes a law of vanishing returns.

As we talked about how this judge was using his monitors, it quickly became apparent to me that he was on to something. He talked in detail about his workflow as he reviewed and prepared. On one of PAGE

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the portrait monitors he displayed a pleading. On a portrait monitor directly next to the first, he displayed any other documents he needed to quickly reference or compare. On this third monitor he had an application open for taking notes as well as his email and other often used applications. His goal was to maximize the information that was always in front of him, and minimize the need to click around from open window to open window.

In response to my question about his motivation for improving his efficiency he said: “Unlike most of the attorneys who argue cases in front of me, I don’t get paid by the hour. And I like to spend time doing other things I enjoy outside of the courtroom and my office.”

The judge’s explanation was convincing. So naturally you would assume I ran out and obtained a third

monitor.

But your assumption would be wrong. I ended up sticking with two monitors at the time.

As I listed to the judge’s description of how he was using his multiple monitors, it occurred to me that the number was not the key.

Rather, it was the demands of his particular workflow and processes.

Efficiency experts encourage us to “stage” our workflow in our offices to minimize excess work. For example, having supplies for binding copies together near the copier.

The same is true on our computer monitors. At the time of this conversation I evaluated my particular needs and workflow and it turned out my two monitors (both in landscape mode) were ideal for my situation. As my responsibilities and tasks have shifted over the years since my conversation with the judge, I’ve added a third monitor to my setup. It works for me.

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As you consider your particular setup, I encourage you to pay close attention primarily to two actions, and how much time and effort those actions take.

First, switching windows. Record how many times you switch windows during a typical work hour. This includes from the time you decide to switch windows to when you execute the switch: moving the cursor, clicking the mouse button, and moving the cursor to the new window. While this is usually only a second or so, if you can see that you are doing this action 30 times during a typical hour, then you are occupying 30 seconds an hour just switching windows. That translates into four minutes a day; 20 minutes a week; an hour and 20 minutes a month; and 16 hours a year.

Compare that to moving your cursor from a window in one monitor to another monitor. Assuming this typically takes about half a second you have just gained 8 hours a year of efficiency. That may not seem like a lot, but we are only looking at one action so far.

The second action to pay attention to is the amount of time it takes to mentally process information as you switch windows. Often the information you were just looking at is information that informs the action you will take in the next window. So you must commit that information to memory and then move your mouse, click on the window you want to access, and then move your mouse to where you want it in the window. Have you ever found yourself going back and forth to double-check that you have the right information?

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Instead of absorbing information, moving your cursor, clicking, moving your cursor, and then applying information, suppose you could take in information, slightly turn your head or eyes, move your cursor, and apply information? In the latter scenario, you’ve already saved time and improved efficiency. In other words, instead of swapping back and forth between windows, you can simply shift your eyes back and forth, improving efficiency. That 8 hours saved a year will actually be much higher than that.

As you consider ways to make your office technology work for you, consider how the use of multiple monitors can create efficiencies for you and your staff. The bottom line benefit may be well worth cost.

ABOUT THE AUTHOR Blair Janis is Technology Director at WealthCounsel where he provides technology systems and education to estate and business planning attorneys. Blair has over 20 years of programming and system development experience in various industries including higher education, telephony, aviation, government, and legal. Prior to joining WealthCounsel in May 2007, Blair was the Practice Applications Manager at Ballard, Spahr, Andrews & Ingersoll, where he developed and applied practice-specific technology for the firm’s 450+ attorneys. Blair received his JD, cum laude, in April, 2001 from the J. Rueben Clark Law School at Brigham Young University.

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IRC Section 280E: A TAX THORN IN THE SIDE OF MARIJUANA BUSINESSES JENNIFER L. VILLIER, JD, WEALTHCOUSEL LEGAL EDUCATION FACULTY The number of U.S. states that have legalized medical or recreational marijuana (or both) has grown to 23, plus the District of Columbia. Despite state legalization of the drug, the federal Controlled Substances Act still categorizes marijuana as a Schedule 1 drug.

So although nearly half the states have legalized the sale of marijuana for medicinal or recreational purposes, federal penalties for the sale of less than 50 kilograms of marijuana is punishable by up to 5 years in prison and a $250,000 fine. The disconnect between state and federal legal treatment of marijuana has resulted in many issues and uncertainties for businesses connected to the marijuana industry.1 As marijuana legalization continues to spread across the U.S., many business owners look to attorneys to advise them on the opportunities and consequences of the gaps between state and federal law and the impact of the Internal Revenue Code (“IRC”) on marijuana businesses.

In addition to the banking and employment law issues marijuana businesses face, tax issues have arisen as the Internal Revenue Service (“IRS”) and courts consider the applicability of various IRC provisions to state-authorized marijuana operations. One such provision, §280E, is the subject of this article. Specifically, this article discusses the implications of the 9th Circuit’s recent decision in Olive v. Comm’r,2 which affirmed the Tax Court’s holding that §280E disallows the deduction of ordinary and necessary business expenses by businesses engaged solely in the sale of marijuana.

FACTS The marijuana business at issue in Olive was the Vapor Room Herbal Center (“Vapor Room”) located in

San Francisco, California, where the sale and use of medical marijuana is legal. Vapor Room’s activities included (i) selling medical marijuana; (ii) providing patrons with a place to socialize, play games, read and create artwork in a community center-like atmosphere; (iii) offering yoga, movies and massage therapy; (iv) stocking tea, water, pizza, sandwiches and other snacks for patrons’ consumption; (v) counseling patrons on personal, legal or political matters pertaining to medical marijuana; (vi) loaning vaporizers to patrons to enable them to inhale a THC-containing vapor using marijuana purchased at Vapor Room or elsewhere. Notably, Vapor Room charged patrons only for the marijuana; everything else was offered at no cost.

Vapor Room’s federal income tax returns for 2004 and 2005 reported net income for those years of $64,670 and $33,778, respectively. Vapor Room reported $236,502 (for 2004) and $417,569 (for 2005) in business expenses related to its operations during those years. The Tax Court held that, pursuant to §280E, none of those business expenses were deductible.3 The 9th Circuit affirmed.

ANALYSIS Under IRC §§61(a)(2) and 162(a), individuals and businesses are taxed on gross income less permitted deductions. IRC §§261-280H list items not deductible from gross income, including §280E - amounts paid or incurred for the purpose of carrying on any trade or business that consists of trafficking in controlled substances. The decision in Olive turned on the fact that Vapor Room’s only income-generating activity was the sale of medical marijuana. Because a “trade

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or business” is an activity “entered into with the dominant hope and intent of realizing a profit,” the Court found that Vapor Room’s “trade or business” was limited to medical marijuana sales, which is prohibited by federal law. Therefore, §280E precluded Vapor’s Room deduction of any of its business expenses.

The petitioner, Martin Olive, Vapor Room’s operator, argued that Vapor Room not only sells medical marijuana, but it also provides caregiving services.

Therefore, according to the petitioner, Vapor Room’s trade or business does not solely “consist of” medical marijuana sales. In support of his argument, the petitioner cited CHAMP,4 a 2007 opinion in which the Tax Court held that a medical marijuana business that also provided extensive counseling and caregiving services was engaged in more than one trade or business. The Tax Court determined that the CHAMP enterprise’s primary purpose was to provide caregiving services and its secondary purpose was to provide medical marijuana. While §280E disallowed the deduction of expenses incurred in connection with the provision of medical marijuana, the business in CHAMP was able to deduct expenses incurred in connection with its counseling services. The marijuana business in CHAMP charged its patrons a membership fee to partake in its marijuana and counseling services.

Olive, in the 9th Circuit’s opinion, can be distinguished by the fact that Vapor Room does not charge a sep-

arate fee for its counseling services, caregiving or snacks. Rather, Vapor Room charges its patrons for marijuana based upon the quantity and quality of the product, and on the individual customer’s ability to pay. Ultimately, the free goods and services Vapor Room offered were viewed by the Court merely as a means to attract paying customers for its medical marijuana.

TAKEAWAYS The holding in Olive seems straightforward enough.

When running a state-authorized medical (or recreational) marijuana outfit, in order to prevent §280E from disallowing the deduction of all business expenses, businesses should ensure that any supplemental activities or services are provided for a fee.

Additionally, businesses should maintain accurate and detailed records of business expenses so that they can be properly traced and proven to have been incurred in connection with either the marijuana trade or business (not deductible) or the non-marijuana trade or business (deductible).

If marijuana sales and use are ever legalized on the federal level, the §280E penalty on state-authorized marijuana establishments should fall by the wayside.

Until then, §280E serves as a means by which the federal government can enforce a tax on marijuana businesses. Thus, the federal government may not be interfering with the use, distribution, possession or cultivation of marijuana in states where it is legal, but it is certainly making it more costly to run a dispensary.

ENDNOTES 1 For a discussion of the banking and employment law considerations facing marijuana businesses, as well as ethical issues facing attorneys that represent them, please see The Legal Quagmire of Marijuana Regulation, WealthCounsel Thought Paper (June, 2015).

2 Olive v. Comm’r of Internal Revenue, No. 13-70510 (9th Cir. 2015) 3 Olive v. Comm’r of Internal Revenue, No. 14406-08 (T.C. 2012) 4 Californians Helping to Alleviate Medical Problems, Inc. v.

Comm’r (CHAMP), 128 T.C. 173 (2007)

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Marital Planning in the Joint Trust: BALANCING INCOME TAX, TRANSFER TAX, AND ASSET PROTECTION CONCERNS BRENDA L. GEIGER, JD, WEALTHCOUNSEL MEMBER SINCE 2007 Marital planning in the joint trust context can be complex. This article examines the tax and non-tax implications of four main marital options upon the death of the first spouse. The options we will explore are: (1) leaving all property

to a spouse in a survivor’s trust; (2) dividing the property into an A trust and B trust after the death of the first spouse; (3) leaving all of the deceased spouse’s property to the surviving spouse and including provisions for the surviving spouse

to disclaim to a bypass trust; and (4) using a Clayton election after the death of the first spouse.

The four approaches outlined above are the most common forms of marital planning in the joint

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trust, but they often apply to separate trusts in separate property states as well.

ALL TO THE SURVIVING SPOUSE The first option is the simplest. If husband and wife so desire, they can leave everything to the surviving spouse either outright or in further trust in a survivor’s trust.

Directing property to a Survivor’s trust would allow the trust to continue without requiring the surviving spouse to later create a new individual trust after the death of the first spouse. With this option, the surviving spouse has full control over the trust property left to them by the deceased spouse. The surviving spouse may change the plan later by revoking or amending the trust.

For federal estate tax purposes, the entire trust estate is includible in the surviving spouse’s estate. If

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only one spouse’s estate tax exclusion is needed to shelter the entire estate, this may be a viable option for the couple. But other non-tax issues must be assessed as discussed below. The property owned in the survivor’s trust at the death of the surviving spouse also receives a basis adjustment when the remainder beneficiaries later inherit.

This type of plan is simple and effective, but it does have drawbacks. If the surviving spouse later remarries, nothing prevents them from changing the beneficiaries of the trust to the new spouse or the new spouse’s children, or from terminating the trust and moving the assets to a joint trust with the new spouse. Those assets could be later taken in a divorce.

There is also no asset protection for the surviving spouse over the deceased spouse’s share; the assets may be used to satisfy judgments in lawsuits, accessible to

creditors or included in bankruptcy. But where husband and wife have a long, stable, single marriage, a smaller estate, and are not concerned with asset protection or remarriage issues, this may be a viable option. (One postmortem strategy may include porting the deceased spouse’s unused exemption amount through a portability election on a 706 Federal Estate Tax return, even when the estate is nontaxable.)

MANDATORY FUNDING APPROACHES The second option is to divide the trust estate into an A and a B trust through various marital deduction funding formulas. These formulas include the pecuniary marital formula, fractional marital formula, and the pecuniary credit shelter formula. Each approach divides the decedent’s estate into shares at his or her death, often creating a

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share covered by all or part of the decedent’s Applicable Exclusion Amount, and another share (or shares) covered by the unlimited marital deduction. Because these are mandatory funding formulas, the surviving spouse must divide the trust according to the formula at the death of the first spouse.

Years ago, this form of marital planning was quite common because the estate tax exemption was comparatively low. The main driver for this type of plan was the desire to use each spouse’s federal estate tax exemption (and often, where applicable, a state estate tax exemption). The surviving spouse’s estate tax exemption would be applied to the survivor’s trust – and any other assets owned in their name at death – and the deceased spouse’s exemption would shelter the bypass trust assets (and any assets passed outside the trust not going to the spouse).

When the federal estate tax exemption was fairly low, many families in America were motivated to establish mandatory marital deduction formula-based estate plans. For example, in 2001, the federal estate tax exemption was $675,000 with a top tax rate of 55%. With life insurance owned in the name of the decedent includible in this exemption calculation, many couples were almost forced into A/B trust planning to save estate taxes.

Today, with the option for a portability election on the 706 estate tax return at the death of the first spouse, the exemption can be used by a surviving spouse after the first spouse dies. But there are some limitations to relying on portability.

From an income tax perspective,

creation of a bypass trust at the death of the first spouse has some drawbacks. Assets funded into the bypass trust receive a capital gains tax basis measured at the date of death of the first spouse to die, and do not later receive another basis adjustment when the survivor dies. For example, if a piece of real estate valued at $2MM at the death of the first spouse is funded into the bypass trust and remains there when the survivor later dies, any increase in value from the first spouse’s death until the date of death of the surviving spouse would be subject to capital gains tax liability upon sale.

This result can be avoided with creative planning, but the client must be advised of the income tax implications. For instance, if the surviving spouse sells the property from the bypass trust in exchange for a note, or if the survivor replaced it with other assets not subject to gain, the income tax problem can be mitigated.

Today, much of the planning around mandatory method A/B marital trusts involves larger estates. It may also enter the planning conversation where a spouse wants to ensure the eventual remainder beneficiaries originally chosen by the couple are not later disinherited. And often spouses seek asset protection for the surviving spouse from predatory creditors.

THE MARITAL DISCLAIMER APPROACH A third option is to design the trust to pass all of the trust assets to the surviving spouse outright or in a survivor’s trust and reserve the

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option for the surviving spouse to disclaim all or a portion of the decedent’s share to a B (bypass trust). A disclaimer is a refusal by someone to accept property that they are otherwise due to receive.

The person signing the disclaimer (the “disclaimant”) makes an irrevocable and unqualified decision to refuse any interest in the disclaimed property. The disclaimer must comply with federal and state law. This type of planning is often referred to as “disclaimer trust” planning.

The disclaimer trust is a common form of “wait and see” planning for married couples. They may want to defer the decision to use a bypass trust for estate tax purposes or for asset protection for the surviving spouse. In a disclaimer trust plan, the surviving spouse may decide to disclaim property left to them by their spouse in trust, but they are not required to do so. If the surviving spouse disclaims property received from the deceased spouse, the disclaimed property is transferred to the bypass trust.

The bypass trust is typically drafted so that the surviving spouse manages it as trustee and has access to income (and often principal, limited to the ascertainable standard of health, education, maintenance, and support, or “HEMS”). As an exception under IRC §2518(b)(4) (A), the surviving spouse may benefit from the disclaimed assets in the bypass trust, but the assets are not included in the survivor’s gross estate when they die. If it were not for this, and possible asset protection of the disclaimed assets (depending on state law and the timing of the disclaimer), there would

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be little reason for a surviving spouse to disclaim. At the death of the first spouse to die, if the survivor desires asset protection for the assets disclaimed, creation of the bypass trust may make sense if the assets being disclaimed are not likely to trigger a later taxable gain, and even if the deceased’s spouse’s unified credit is not needed to mitigate estate tax.

The key advantage to this type of plan is the ability to assess the estate at the death of the first to die. The decision can be made then to create a bypass trust if the estate has grown significantly, if the estate tax exemption has decreased, or where asset protection is desired. The spouse may also decide to file a 706 and claim portability of the deceased spouse’s Unused Exclusion Amount (DSUEA).

If the surviving spouse appoints a third party independent trustee over the bypass trust, the trust may contain a broader, non-ascertainable distribution standard, further increasing the asset protection for the bypass trust.

The obvious problem with a disclaimer trust plan is that the surviving spouse may fail to disclaim when it makes the most sense. They may also fail to disclaim because they do not obtain sound legal advice. This point becomes even more poignant when there is a blended family. The surviving spouse may later change his or her mind and decide not to disclaim the decedent’s assets to a bypass trust. Those assets may then be given to other beneficiaries that were never intended when the couple first established their plan.

The surviving spouse may also accidentally void the opportunity to disclaim. There are specific state and federal requirements that must be followed in order to make an effective disclaimer. For example, a disclaimer

can fail if the surviving spouse manipulates the decedent’s assets in any way that constitutes acceptance of the property. This could happen if the surviving spouse moved the property from one account to another or sold the property and replaced it with another asset, for example.

THE CLAYTON ELECTION Finally, we consider the Clayton election. This option provides more flexibility for A/B trust planning without all the limitations on capital gains tax treatment for bypass trust assets when the surviving spouse later dies. With this strategy, the plan is designed as A/B trust plan, but allows an independent executor to elect QTIP treatment over the deceased spouse’s assets by an election made on the decedent’s 706. The election may include up to the entire amount deceased spouse’s share.

Any property of the decedent for which the QTIP election is not made then funds the bypass trust. Assets in the QTIP trust would be includible in the surviving spouse’s estate at death, receiving a step up in basis at that time. If the beneficiaries later sell assets that were inherited through the QTIP trust, the capital gains tax liability is much lower (often zero).

The bypass trust and the QTIP trust can be drafted to be substantially the same.

This way the spouse who dies first can ensure that the remainder beneficiaries of the trust are not later changed (subject to any testamentary power of appointment given to the surviving spouse).

If there is a long standing marriage with joint children, the couple may want to give the surviving spouse a testamentary limited power of appointment to reallocate the assets of the QTIP or bypass trusts among their descendants, charities, and/or spouses of descendants. But

in a blended family the couple may not want this provision because the surviving spouse could reallocate the bypass or QTIP trust assets, disinheriting the deceased spouse’s children or other beneficiaries.

Another advantage of the Clayton approach is that the election is made by an independent executor to avoid potential gift tax exposure by the surviving spouse. It also provides more objectivity in considering the benefits and drawbacks, especially in a blended family.

Because the Clayton election is made on a timely-filed 706, the decision to send assets to the QTIP trust must be made within 9 months of the death of the first spouse to die. (A 6-month extension may be obtained, extending the time to make the election up to 15 months.)

There is an added cost to have a 706 prepared after the death of the first spouse, but on the whole, there are great advantages to the Clayton election. These include asset protection for the deceased spouse’s share, continuity of the remainder beneficiaries and an additional basis adjustment for assets in the QTIP trust after the surviving spouse later dies.

Because the Clayton election is made on the 706, this provides the additional opportunity to claim portability of the deceased spouse’s Unused Exemption Amount. In some respects, the couple can have their cake and eat it too.

The surviving spouse’s A trust property and the property in the QTIP trust is included in the survi-

vor’s estate. Those assets receive a second step-up in basis when the surviving spouse later dies. But the survivor may also leverage the deceased spouse’s ported estate tax exemption in case it’s later necessary to use it. The survivor enjoys asset protection in the QTIP trust, and the “reverse QTIP election” can also leverage the deceased spouse’s GST tax exemption. (This is important because the deceased spouse’s estate tax exclusion is portable, but the GST exclusion is not.)

Flexibility is the key to the Clayton election’s power. For smaller and medium-sized estates, we won’t know the best course of action until the death of the first spouse to die. We may want to place assets that are rapidly appreciating into a QTIP so we secure a step-up in basis and avoid capital gains tax upon the death of the surviving spouse. Other clients may opt for the stronger asset protection features of a bypass trust, especially if capital gains exposure is not a major factor when funding the plan after the death of the first spouse.

It is important to note that using portability to preserve a first spouse’s exemption has some flaws. The DSUEA does not adjust for inflation, and it may be lost upon remarriage of the surviving spouse. In this scenario, using a bypass trust may make more sense to preserve the use of the DSUEA. (Editor’s note: But the survivor may also use the DSUEA to

fund an irrevocable trust after the death of the first spouse, using the DSUEA proactively, rather than by a default bypass trust. – mm) Protection for children from a prior marriage is arguably superior with a bypass trust as well since we would not be at risk of an independent executor failing to make the QTIP election. Allocation of the deceased spouse’s GST exemption to a bypass can be more easily accomplished as well.

SO WHICH APPROACH IS “BEST”?

There are several “soft” issues to consider when recommending a plan to a client. These issues include the desire to provide asset protection for the surviving spouse and to preserve the jointly-chosen remainder beneficiaries after the death of the first to die.

As counselors we are often asked which plan the client should elect.

Unfortunately, the answer is not always clear. We must dig deep with clients to assess not only the transfer tax ramifications, but the income tax implications as well. We must also explore the couple’s tolerance for risk associated with allowing the survivor to change the plan after the first spouse’s death.

This issue becomes even more complex when there is a blended marriage in which one or both of the spouses have children from a prior marriage.

ABOUT THE AUTHOR Brenda Geiger’s practice is located in Carlsbad, California. Her firm focuses on mid-level and high net worth estate planning, asset protection, business planning, trust administration, and elder law.

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Matt McClintock sat down with Leonard Weiner for this issue’s member spotlight.

Len is the principal of Weiner & McCulloch, PLLC, a tax and estate planning firm in Houston. Len is licensed in 39 states, most by admission on examination. In fact, he is licensed in states where 94% of all Americans live. An early pioneer of family limited partnership (FLP) planning, Len prefers to collaborate with other attorneys and with other professionals. He joined WealthCounsel in 2002.

Member Spotlight LEONARD WEINER WealthCounsel Member since 2002

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MM: Len, introduce me to your practice.

I had a great-uncle who was an attorney and who had a great reputation in the community. He was respected, ethical, and very kind. I learned from him that the highest role of the lawyer is to help people. I enjoy helping people so practicing law was a good fit for me. My uncle was a great role model.

I’ve been in practice now for about thirty years. I grew up in Houston, but I went away for a few years for college. I attended the Wharton School of Finance (in Pennsylvania) and then law school at Georgetown University (DC). After I graduated I returned to Houston.

Early in my practice I did some litigation. I’m glad I don’t do it anymore, but I’m happy I had that experience. Being able to speak “litigator” allows me to help clients like a general counsel, and to coordinate with their litigation counsel. I can communicate with my client and the litigator. I can help the client understand what is going on in the litigation so they are better prepared and help the litigator better understand the client’s business.

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MM: If you have an overarching philosophy for your practice, what is it?

I strongly believe in the value of collaboration among professionals. During my career I’ve had the opportunity to collaborate with many different types of professionals. I learned early on that embracing a spirit of collegiality and collaboration with other professionals enabled me to grow in my own knowledge and experience, serve clients more completely and do more interesting work, polish my skills, and get to know a lot of great people. It shortened my learning curve.

And when professionals collaborate, the client wins.

When different professionals – even sometimes competitors in the same market – are able to work together for a client they provide a good level of quality control. We all have different strengths and different levels of experience, so sometimes a colleague identifies an opportunity that I’ve overlooked. Sometimes it’s the other way around.

Working with mature professionals from other industries in a collaborative environment is rewarding both financially and personally, and it helps identify addi-

WEINER & MCCULLOCH, PLLC 5599 San Felipe St #900 Houston, TX 77056 (713) 624-4294 www.HoustonElderLawyer.com

As our firm has grown we now have five attorneys plus one part-time “of counsel” attorney. Four of us are attorneys and CPAs, and that has helped us work with other CPAs and other attorneys. Because of our tax background we tend to practice more heavily in transfer tax and income tax planning, but we also help clients with business planning and business law matters. We’ve found that often a client’s needs overlap many different focus areas, so we help them as completely as possible.

tional planning opportunities so the client gets more complete service. When we work together, we help clear those obstacles that stand in the way of progress, allowing the client to move forward with good recommendations from multiple specialties.

MM: What have you found to be some obstacles to high quality collaboration, and how have you worked through them?

I’ve found that collaboration gets easier the older I

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get, and the older the other professionals are. We all tend to get a little mellower and wiser with time, and more confident in our own abilities.

Some professionals feel a need to “own” the client relationship. In my experience, that mindset tends to create obstacles instead of solutions for the client. I try to put the client first with collaborative relationships and demonstrate that we can all better serve clients. I’m here to help other professionals and support their relationship with the client, and move the client forward with successful planning.

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MM: How have you adapted your practice as federal tax law has evolved, especially after ATRA? When the federal estate tax exemptions started rising under the Bush administration I saw a shift coming.

Although I have a strong tax background, I started concentrating more on the non-tax aspects of estate planning. I went through the process of becoming a Certified Elder Law Attorney (CELA), and that helped me better understand the more personal and human side of what we do for clients. While the fear of taxes might be an incentive for prospects to consult with

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us, clients move forward more often because of the “softer side” of planning that we focus on.

for capital gains tax purposes when the survivor later passes away.

As a specific example, we have helped clients establish clarity concerning their health care decisions. While I generally don’t like very extensive planning questionnaires for clients, our health care questionnaires are very detailed.

MM: What specific skills have been the most helpful in your practice?

We also help clients with broader planning issues.

We have helped eligible clients save significant income and transfer taxes and obtain a better and more economically measurable protection by establishing high quality, bona fide, domestic captive insurance companies. These allow clients to obtain insurance they might not otherwise be able to get, save premiums and potentially save income taxes to build reserves in their captive. With proper facts and planning, the captives also allow clients to save transfer taxes.

We have helped higher net worth clients with a trust strategy that helps them save both income tax and transfer tax (estate, gift, and GST). The clients may be their own HEMS trustee and retain full managerial control. Best of all, the clients may be the beneficiaries so they also can benefit from the trust. Children will not receive distributions until the parents want them to be made. It eliminates the annual administration duties that clients frequently fail to perform and there is no gift tax. It also helps to increase family wealth because trust asset appreciation compounds in the trust for many generations and income may compound in the trust income tax-free during the client’s lifetime.

We help business owner clients deal with transitioning their businesses, and have focused on the income tax opportunities available when structuring ESOPs and other strategic exit plans for their businesses. ESOPs can help eligible owners use tax benefits to get a better selling price, better terms, and better security that they will be paid.

And like many other WealthCounsel members, after ATRA we have expanded our focus on income tax. Because I believe in many of the nontax benefits of using a bypass trust for the surviving spouse, we include options to trigger estate inclusion for the survivor so they get another basis adjustment

I have focused on developing three skills and they’ve been a great help: creativity, a commitment to listening, and providing clear communication to clients.

First, creativity has helped me since the beginning because when I started my practice, three of the five largest law firms in the country were here in Houston. I didn’t have the resources to build a comprehensive research library, so I had to learn to run a little faster and think more creatively to succeed in practice.

Second, I try to do as much careful listening as possible. I focus both on the client’s words and the emotion and ideas behind those words, so I can make recommendations for the client’s needs as accurately as possible.

And third, I work hard to overcome the legal jargon we all use. My clients are smart people, but in our industry we speak a special language. I try to communicate ideas and strategies in plain English because when clients understand the strategy, it’s much more likely to succeed for them.

Many clients are reluctant to tell you when they’re confused. I try to simplify explanations and to make the client’s experience as comfortable and useful to them as possible.

It’s a constant process of trying to improve these skills, too. I know I can always do better, and reflect back on meetings and ask myself, “What went well? Is there some way I could have explained that better? Is there anything I need to clarify further with them?”

MM: What are some of the greatest challenges you’ve faced in building a successful practice?

First, you have to learn how to juggle a lot of balls at the same time. There are so many things to keep moving that are very time consuming. Overseeing operations, managing the practice, nurturing collaborative relationships, meeting with clients, get-

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“ IT’S MORE IMPORTANT NOW THAN EVER FOR ATTORNEYS EARLY IN THEIR CAREERS TO FIND MENTORS WHO WILL TAKE AN INTEREST IN THEM AND THEIR PRACTICE.

“

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ting the work done…

The other challenge is simply managing other people’s expectations. Collaborators, clients, and other advisors often expect more than is realistically possible.

Helping them reset their expectations is important.

Most people have no idea what kind of work is involved in providing high quality planning and documents. To a certain degree it’s like a black box. There is a limited amount of time clients are willing to spend to learn what they need and what they should do to help them achieve their goals.

MM: How would you describe your ideal client?

I can sum that up in one word: Huggable!

If a client is huggable, I know everything will be good. Working for clients with

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larger net worth is nice because I know I can hit more home runs for them; there are more opportunities to do interesting and effective planning. I find that higher net worth clients will want more service and help from us, which will take more time. But I get personal reward getting to know each of my clients and being able to relate to them on a human level.

There is a challenge: I would like a practice that is more high touch, but it’s tough to balance the economics of that and what clients think they should pay in fees. Most importantly, I want my clients to get the right result with an outcome they can feel good about and understand. When I can establish a relationship with a client and they open up and move toward a great planning solution, that’s a big win. Getting to know the client at a human level really helps to make that happen.

MM: What advice would you give an attorney who is looking to start a practice?

I think the business is harder now. It seems like there

9 NUMBER 3 / Q3 2015

are more attorneys going after fewer estate planning clients. The work is complex, because you have to balance a client’s transfer tax needs against income tax needs, business planning needs, and the important “softer issues” for the client.

It’s more important now than ever for attorneys early in their careers to find mentors who will take an interest in them and their practice. Finding a great organization to be a part of and invest in can go a long way toward connecting a newer attorney with experienced folks. I’ve been fortunate to be a part of some of those groups, including WealthCounsel.

Many bar organizations aren’t as personal. It’s often harder to get involved there. A good organization of similarly-minded professionals can help people connect so that they don’t feel alone in practice. It can also be a place for good advice and fresh ideas. When we collaborate with each other it puts us all ahead.

I’ve seen that as a member of WealthCounsel. The spirit of mentorship and collaboration is so important when you’re in a small firm or a solo practitioner.

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Incomplete Gift, Non-Grantor Trusts (AKA DINGs, NINGs) ED MORROW, JD, LLM, CFP速, WEALTHCOUNSEL MEMBER SINCE 2015

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This article will introduce estate planners to an important weapon in their trust planning arsenal – the incomplete gift, non-grantor trust. These trusts are often colloquially known as DINGs or NINGs, short for Delaware or Nevada Incomplete Gift Non Grantor Trusts. Delaware and Nevada gained prominence because of private letter rulings (PLRs) that concerned trusts using Domestic Asset Protection Trust (DAPT) statutes and had trustees from those states; however, other states with similarly strong DAPT laws, that would not typically tax trusts, such as Alaska, Wyoming or Ohio, may also be used. For simplicity, we’ll use the more common DING acronym in this article.

We’ll explain what it is, why it’s used, what state limitations exist and how it can be used beyond state income tax avoidance.

What is a DING? A DING trust has two unique tax characteristics: first, as the name implies, it is an incomplete gift. Warren Buffett could transfer billions

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to such a trust, with no initial gift or estate tax effect (other than opportunity cost by not funding another trust instead). The trust is designed to be included in one’s estate, so it is primarily an income tax, rather than estate tax, tool.

Secondly, unlike most estate planning trusts established during a settlor’s lifetime, it is a non-grantor trust. This means it is considered a separate taxpayer for income tax purposes, rather than ignored for income tax purposes (aka grantor trust), like a GRAT or revocable living trust is during a settlor’s lifetime.

So what? Why should I care? Trusts that are separate taxpayers can often be established as “non-resident trusts” for state income tax purposes. Thus, the DING design often allows the trust to escape state income tax. The savings can be tremendous, depending on the state and amount avoided. Thus, DINGs are trusts that have all of the asset protection characteristics of a DAPT (perhaps even stronger), but with the add-

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ed benefit of being able to avoid state income tax in many situations.

I practice in a state with very low or no state income tax. Should I care? Yes! While DINGs are primarily known as state income tax avoidance and asset protection vehicles, they can also be used for more advantageous federal tax benefits in certain situations.

For example, when taxpayers are charitably minded or desirous of shifting income tax burden to beneficiaries who are in lower income tax brackets. Nongrantor trust taxation enables much more advantageous deductions in those areas.

Who are the best candidates for DINGs? DINGs are not for the average middle class client. Normally, these will best fit clients who could realize at least $50,000 of state income tax savings from a pending sale of assets, or have several hundred thousand in portfolio income annually, to justify the hassle and expense. It is usually the one-time large income realization event that is most appealing. Other candidates are those clients who may be charitably minded or would prefer to make gifts to beneficiaries that shift income at the same time.

Does this technique work to avoid state income tax in all states? Not necessarily, at least, not without a fight! There are a few states that consider a trust to be a “resident trust” for state income tax purposes no matter where the trustee is, where the administration occurs, which law applies to the trust, where the beneficiaries reside or where the assets are located!

Maine, for example, will tax trusts based solely on the residency of the settlor.

States that have very broad taxing statutes based only on a settlor’s residency, however, have a good chance of being declared unconstitutional if your client is willing to battle the state tax department in court. North Carolina’s statute was recently held unconstitutional by a lower court, even though there were in-state beneficiaries! There is a substantial trend of recent cases, based in part on the Supreme Court’s 1992 decision in Quill v. U.S., that holds such statutes as violative of the dormant commerce and due process clauses. Practitioners in those broadtaxing states, and their clients, will need to have a higher dollar amount at stake and a higher threshold of tolerance for potential litigation to justify using such trusts.

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SUMMATION OF THE FEDERAL TRUST INCOME TAX SCHEME AFFECTING DINGS Trusts and estates have similarities to pass-through entities, but are taxed quite differently from entities taxed as S corporations and partnerships – usually, capital gains are trapped and taxed to the trust and other income is taxed to the beneficiaries to the extent distributed and to the trust to the extent not distributed. That is a highly condensed summary of a complex subject.

SUMMATION OF THE FEDERAL GIFT/ ESTATE TAX SCHEME AFFECTING DINGS As mentioned, the initial funding of a DING is a “nonevent” for federal gift/estate/GST purposes, but when distributions are later made from the DING to anyone other than the settlor, the distributions may “complete” the gift. Distributions to a spouse may qualify for the marital deduction. Distributions to a charity may qualify for a charitable deduction. Distributions to other parties may use annual or lifetime gift exclusions (or beyond that, perhaps even cause a tax).

STATE TRUST INCOME TAX SCHEMES DIFFERENTIATING RESIDENT AND NONRESIDENT TRUSTS Most states (other than perhaps Pennsylvania, and more recently, New York) follow the federal grantor/ non-grantor trust scheme. Avoiding state trust income tax is essentially a three-step process: 1) avoid being a “resident trust” in the state of residency, 2) avoid “source income” in the state of residency, and 3) ensure that the trust does not trigger taxation in any other state through the use of out-of-state trustees or administration. Let’s take the first step.

Avoiding characterization as a resident trust varies greatly state to state. This short article cannot analyze the dozens of jurisdictions, but to generalize, this is usually accomplished by avoiding one or more of the following: the use of an in-state trustee or fiduciary, avoiding assets in state, administration in state, and sometimes even current beneficiaries in state.

This latter trigger sounds nearly impossible to avoid

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for most clients, but this can often be worked around as well.1 As discussed above, states that consider any trust established by a resident settlor are nearly impossible to get around directly, but may be unconstitutional.

Powers of appointment are typically non-fiduciary in nature and such powers should not be considered fiduciary or administrative, though it is probably prudent to reaffirm that such powerholders are not fiduciaries in the trust document. The importance of these distinctions and the pitfalls and opportunities they open up are discussed later herein in the section on designing the DING.

UNDERSTANDING STATE “SOURCE INCOME” – WHEN SOME STATE INCOME TAX CANNOT BE AVOIDED Once we have successfully created a non-resident trust for state income tax purposes, we next need to resolve when and how a state may tax even non-residents and non-resident trusts. The ongoing income of a pass-through entity with ongoing operations or real estate rental income in a state with an income tax is usually taxed to non-residents. However, the sale of the stock (or membership interest) of such entities is not necessarily taxed by a state if the owners are out of state. Thus, stock sales may still present a tax savings opportunity even if underlying company assets are in state.

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trust, and 3) enabling the settlor to have access and/ or control of the trust. Either goal by itself is rather easy for any experienced practitioner to accomplish – all three at once requires some agility.

This article will not go through the DING design in depth, but at its basic level, after the dozens of PLRs released in the last two years, it is a trust with several unique features to enable the above characteristics.2 The first three below refer to the how distributions are made.

The settlor retains a lifetime and testamentary limited power of appointment solely exercisable by him/herself. Only a few DAPT states, such as Nevada, Delaware and Ohio, clearly permit this without compromising asset protection. This feature is designed to make the gift incomplete yet be curtailed enough so as not to cause the trust to become a grantor trust. Lifetime distributions to appointees are limited to a standard such as health, education, maintenance and support to prevent grantor trust status, or possibly limited to charitable beneficiaries (this latter idea is not in the PLRs, but could probably work equally well).

More importantly, there is a distribution committee comprised of adverse parties (beneficiaries) who control distributions. The trustee would not control distributions at all during the settlor’s lifetime. This is necessary to enable distributions back to the settlor and/or spouse without triggering grantor trust treatment. The committee structure is necessary to prevent adverse estate/gift tax effects to the powerholders or grantor trust status as to powerholders.

WHAT DESIGN FEATURES MAKE DING TRUSTS UNIQUE?

There is a veto/consent power unless the distribution committee unanimously overrules the settlor – this is designed to make the gift incomplete.

The design of DINGs is slightly more complicated than most trusts due to the conflicting goals of 1) making the gift incomplete; 2) making the trust a non-grantor

The trust is established in a state that permits selfsettled DAPTs and would not otherwise tax the trust or beneficiaries. This ensures asset protection for the

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settlor and powerholders, but less obviously, it is also designed to prevent grantor trust status.3 Without getting into gritty detail, the dozens of rulings on these types of trusts point to a design whereby, for many taxpayers and situations, we have the perfect tax design – the ability to use nongrantor trust taxation without having to use gift tax exclusion. Yet, the settlor keeps enough control and flexibility not to offend other non-tax estate planning goals.

How does this trust function as a practical matter?

The management and reporting is like any trust, but the distribution provisions are what make it unique. The distribution committee uses a jointly held limited power of appointment to appoint cash or property during the settlor’s lifetime, in lieu of a traditional trustee spray power or direction from the settlor. In addition, the settlor retains a limited power. Together, there is ample flexibility to make distributions – indeed, more flexibility than most trusts that are typically more limited in the trustee’s ability to distribute assets.

There are even greater advantages that may be had using a charitable remainder trust as an appointee of trust distributions. This will be the subject of a future article to be published in fall of 2015.

CONCLUSION To summarize, establishing a DING trust can often legitimately avoid state income taxes on traditional portfolio income, including capital gains and sales

of closely held C corps, income from pass-through entities owning out of state property or out of state businesses and often the proceeds of “stock sales” of LLC or S corporation interests, even if the underlying assets are in state.

Additionally, DINGs have significant asset protection, family management, and even federal income tax benefits for taxpayers with income above the highest income tax bracket. For anyone not in the highest two federal tax brackets, income trapped in trust at the highest income tax bracket starting at only $12,300 is too high a price to pay to make any trust strategy avoiding state income tax worthwhile. Therefore, the clients for whom such a strategy is most useful are those wealthy enough to have significant annual income above the highest federal tax bracket (over half a million dollars) or anticipate future income to be well over that due to anticipated capital gains or other windfall.

ENDNOTES 1 See my analysis of avoiding Ohio’s version which is triggered by beneficiary residency in The Art of Avoiding Ohio Income Tax Using Trusts, in May 2014 issue of the Probate Law Journal of Ohio 2 See various presentations by author on this subject for more detail, such as those available from the Symposium CLE presented with Jeremiah Barlow. Recent PLRs include: PLRs 201310002 to 201410006,PLRs 201410001 to 201410010, PLRs 201426014,PLR 201427008; PLRs 201427010 to 201427015, PLRs 201430003 to 201430007; PLRs 201436008 to 201436032, PLRs 201440008 to 201440012 3 Treas. Reg. §1.677(a)-1(d) – if a settlor’s creditors can reach a trust, this triggers grantor trust status

ABOUT THE AUTHOR Ed is a wealth strategies specialist analyzing tax, trust and estate planning needs of high net worth and ultra high net worth clients of Key Private Bank nationwide. He is also a manager for wealth strategies communications for Key Private Bank’s Wealth Advisory Services, involving the marketing of advanced wealth strategies and training of local teams of credentialed financial planners, trust officers, investment specialists and private bankers. Ed was previously in private law practice working in taxation, probate, estate and business planning. Other experience includes research and writing of legal memoranda for the U.S. District Court of Portland, Oregon as a law clerk. He is outgoing Chair of the Dayton Bar Association’s Estate Planning, Trust and Probate Law Committee.

He is a Board Certified Specialist (Ohio State Bar Assn) in Estate Planning, Trust and Probate Law, a Certified Financial Planner (CFP) and Registered Financial Consultant (RFC). He is also a Non-Public Arbitrator for the Financial Industry Regulatory Authority (FINRA). Ed is a frequent speaker at CLE/CPE courses on asset protection, tax, and various financial and estate planning topics.

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Education Calendar

9 NUMBER 3 / Q3 2015

Q3 SEPT 1

Legal Marketing Quick Start September group

SEPT 22

Business Succession Planning webinar

SEPT 24

Legal Marketing Showcase webinar

SEPT 14-18 Funding Mini-Intensive virtual course SEPT 28-29 Trust Modification virtual course SEPT 17

Word on the Street webinar: Lifetime QTIPs

Q4 OCT 5

Legal Marketing Quick Start October group

NOV 12

Legal Marketing Showcase webinar

OCT 19-30 LLC Operating Agreement Intensive

virtual course

NOV 17 Top 10 Mistakes Non-Tax Lawyers Make

in Drafting LLC Operating Agreements webinar

OCT 22

Legal Marketing Showcase webinar

NOV 19

Word on the Street: Basis Management

OCT 29

Word on the Street webinar: Year End Tax Planning and Looking Ahead to 2016

DEC 1

Legal Marketing Quick Start December group

DEC 9

Year In Review - Business Planning/ Trusts & Estates webinar

DEC 10

Legal Marketing Showcase webinar

NOV 5

Legal Marketing Quick Start November group

NOV 9-20

RLT Drafting Intensive virtual course

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WealthCounsel, LLC P.O. Box 44403 Madison, WI 53744-4403