Obama's Proposed Budget: Making the Death Tax More Deadly

So much for the "permanent" tax law changes that were just enacted a few months ago.  President Obama's new budget now includes an increase in the estate tax along with other measures to make it more difficult for families with larger estates to pass assets onto their children.

In January, the President and Republicans agreed to tax estates at 40% with an exemption of $5 million per person (indexed for inflation).  Obama's budget, however, proposes to raise the top rate to 45% and reduce the exemption to $3.5 million.  This new exemption level would not be indexed for inflation which means that over time, smaller estates would begin to be hit with an estate tax.

In addition, the budget makes proposed changes to utilizing short-term GRATs as well as making gifts of family limited partnerships--techniques which have been used for years to minimize estate and gift taxes. 

Year-End Gift Planning: How Valuation Clauses Can Get Around a Late Appraisal

With the abnormally high gift/estate tax exemption amounts of $5.12 million set to sunset at the end of this year, many attorneys, CPAs and tax-advisors are rushing to help their clients take steps to make significant gifts.  For those who wish to take advantage of this unique opportunity, the clock is winding down.  For the gifts to be effective this year, the transfer must be completed by December 31.

Unfortunately, many planners are now realizing that scheduling appraisals this late in the year means that they will likely not have the appraisal figures back until next year.  Thus, a donor is left to wonder, if I want to make a gift of say, exactly $5.12 million to my children, how do I know how many shares of stock or LLC units to transfer this year if I won't know the value until next year.

Fortunately, due to the availability of defined value clauses and some recent Tax Court cases, the donor (and his/her advisers) can make large gifts with confidence.

In short, a donor need not specificy the exact number of LLC units given, all that needs to be specified is that value to be transferred, expressed in a mathematical formula.

A good example of such a formula clause is found in the recent Wandry decision, and reads as follows:

I hereby assign and transfer as gifts, effective as of January 1, 2004, a

sufficient number of my Units as a Member of Norseman Capital,

LLC, a Colorado limited liability company, so that the fair market

value of such Units for federal gift tax purposes shall be as follows:

                   Name                             Gift Amount

                   Kenneth D. Wandry        $261,000

                   Cynthia A. Wandry           261,000

                   Jason K. Wandry              261,000

                   Jared S. Wandry               261,000

                   Grandchild A                     11,000

                   Grandchild B                     11,000

                   Grandchild C                     11,000

                   Grandchild D                     11,000

                   Grandchild E                     11,000

                                                          1,099,000

Although the number of Units gifted is fixed on the date of the gift, that

number is based on the fair market value of the gifted Units, which

cannot be known on the date of the gift but must be determined after

such date based on all relevant information as of that date.

Furthermore, the value determined is subject to challenge by the

Internal Revenue Service (“IRS”). I intend to have a good-faith

determination of such value made by an independent third-party

professional experienced in such matters and appropriately qualified to

make such a determination. Nevertheless, if, after the number of gifted

Units is determined based on such valuation, the IRS challenges such

valuation and a final determination of a different value is made by the

IRS or a court of law, the number of gifted Units shall be adjusted

accordingly so that the value of the number of Units gifted to each

person equals the amount set forth above, in the same manner as a

federal estate tax formula marital deduction amount would be adjusted

for a valuation redetermination by the IRS and/or a court of law.

In short, while it would be preferrable to get the value before making the gift, a formula clause like the above gives the donor, and other professionals some breathing room.

Of course, one big caveat is to ensure that when the gift tax return is filed that the language on the return matches the language on the gift.  If the return just lists the exact number of shares, units, or percentage interest transferred the donor exposes himself to a potential challenge from the IRS alleging that a formula clause was not utilized. 

NY Times: Wealthy Turn to Family Limited Partnerships

New York Times:  In an Unusual Tax Year, the Wealthy Turn to Partnerships:

A Family limited partnership was once a rather esoteric way for wealthy families to centralize the management of real estate and various pots of money. But this is not a normal tax year.

The arcane device has suddenly become popular because of the scheduled expiration of the $5.12 million gift tax exemption at the end of this year. ... But wealth advisers cautioned that the rush to set up a partnership in order to use the tax break could lead families to do something that is not right for them.

For some families, a partnership is attractive. It is a way to combine money to reach the higher investment requirements that hedge fund and private equity managers require. But its most alluring feature may be the ability to discount the value of the assets put into the partnerships because the shares distributed from it are less liquid since only another family member can buy them.

A discount of 25% generally does not attract scrutiny from the IRS, and that could allow someone to increase a $5.12 million gift exemption to $7 million. Since the partnerships are not overly expensive to administer, several advisers said they have seen people starting them with as little as $2 million. But affluent families on the lower end of that range also risk running afoul of the IRS by being too aggressive in what they put into a partnership and how much they discount it. As families look for ways to get the most out of this year’s gift tax break, many of the advisers I spoke with said they were worried that less sophisticated families would be misled into thinking that they could put everything they had into a family limited partnership and never worry about taxes.

 (See also Family Limited Partnership Video Presentation)

Do My Gifts of Limited Partnership Interests Qualify for the Annual Exlusion?

Under current law, a person has a right to give away $13,000 of assets to as many people as they see fit--free of gift tax.  This is commonly referred to as the "annual exclusion". 

One question that has developed over the years has been whether annual gifts of a family limited partnerships are eligible to qualify for the annual exclusion.  The hiccup was that in order to be considered a gift eligible for the annual exclusion, the gift has to be a gift of a present interest, and not just some future right or benefit. (Reg. 25.2503-3(b).)  The courts have held that in order to qualify as a present interest, the gift must confer a present economic benefit by reason of the use, possession, or enjoyment  i) of property or ii) of income from the property.

The tricky part with gifts of family limited partnership interests is that most of their partnership agreements provide restrictions on transfers--so as to ensure the business interests remain in the family.  The only problem is that the courts view these transfer restrictions as precluding the donees from having the right to use or enjoy the interest in a meaningful way.  Thus, courts are left to consider whether there is income that is of use or benefit to the donee.

The recent case of the Estate of George  H. Wimmer, TC Memo 2012-157, recently considered such a question and reiterated that for gifts of limited partnership interest to qualify for the annual exclusion under the argument that the donee received income, they must prove three things:

1. That the partnership would generate income,
2. That some portion of the income would flow steadily to the donees, and
3. That a portion of the income could be readily ascertained. 

Often, partnership agreements contain language granting the general partners full discretion as to whether or not distributions will be made to the partners--which would not appear to satisfy the second requirement.  In Wimmer, the Court noted that the general partners owed fiduciary duties to the donee limited partners, and that because the donee limited partners were actually irrevocable trusts, the only way such trusts would be able to pay their share of income tax would be for the partnership to make a distribution of income.  Based on these unique facts, the court held that the income would in fact flow steadily to the donees.

In short, before deciding whether to make annual gifts of family limited partnerships, the partnership agreement should be read carefully so as to ensure that it contains language that will ensure such gifts will be treated as present interests and eligible for the annual exclusion. 

Family Limited Partnerships Video Presentation

So I've toyed with the idea of creating short videos discussing various estate and tax planning techniques for quite some time.  I'm more of a visual learner myself and so I tried to figure out if I could create a video that would visually convey some key aspects of the various planning opportunities that are available.  My first video discusses how family limited partnerships can be used to transfer value in a business to your children while still retaining control and how to reap some pretty generous gift and estate tax benefits along the way.  The video is below.  I realize the production quality is a little low-grade but considering it's my first in a series, I think it's not too bad.