Beyond Living
Trusts
The foundation of an estate plan is the living trust. If your estate is more
than $2 million you should consider planning
beyond the living trust. Advanced planning can include the following:
Irrevocable
Insurance Trust (ILIT), a Limited
Liability Company (LLC), a Family Limited Partnership
(FLP),
These are used to protect a client's assets from creditors and to reduce estate
taxes.
How to protect asset and reduce
estate taxes
What
is an LLC?
LLC is shorthand for a limited liability company.
An LLC is a type of business or investment entity that is a unique
combination of corporate and limited partnership characteristics.
As an example, in an LLC, none of the members, the owners are referred to
as members rather than shareholders or limited or general partners, have any
personal liability for debts of the entity itself.
This is referred to as limited liability and thus the name limited
liability company. Corporate
shareholders, likewise, have no personal liability for activities of the
corporation. However, the general
partner in a limited partnership is personally liable for the obligations of the
partnership. This is one reason
that LLCs are becoming increasing popular.
The characteristics that are like a limited partnership are that the
members are taxable on the entity income and the income may be allocated in a
much more flexible manner than in a corporation.
What
do the members in an LLC do?
Most LLCs are termed “member managed” because one
or more of the members does the actual management of the activities of the LLC.
In this case, a managing member is functionally the same as a general
partner in a limited or general partnership.
The non managing members are the same as limited partners in a limited
partnership.
What
kind of client would use an LLC?
With the litigious nature of our society, almost
anyone who needs asset protection could use an LLC.
What
do you mean by asset protection?
For an LLC there are actually to main forms of asset
protection. One is termed “inside
asset protection” and the other is “outside asset protection.”
Remember how we said that a debt of the LLC is not the responsibility of
a managing or non managing member? Well,
that is inside asset protection because debts or other obligations inside the
LLC do not pass through to the members. Therefore,
the members have asset protection from activities occurring inside the LLC.
Likewise, if a member is successfully sued, the successful creditor may
not attach the assets of the LLC. In
other words, events occurring outside the LLC, at the member level, do not
affect the activities of the LLC. In
sum, the LLC has asset protection from events occurring outside the entity,
outside asset protection.
Do
you mean a creditor of a member or of the LLC just has to walk away?
No, if the LLC is successfully sued, the creditor can
take all of the property of the LLC, but if the liability is in excess of the
value of the LLC’s property, the members are protected.
On the other hand, if a member is successfully sued, the property of the
LLC is safe because the creditor
cannot attach the assets of the LLC. However,
the member’s creditor does have limited rights against the member.
The rights are embodied in what is termed a charging order.
A charging order requires the LLC to send any payment it would have
otherwise given to the debtor member to the creditor.
What
if the LLC simply gives the non debtor members distributions and not the debtor
member?
That would be a fraud on the creditor and the law
would require the LLC to pay the creditor the debtor member’s pro rata share
of all distributions. However,
because the creditor has to wait for distributions, reasonable settlements of
the debt frequently occur.
Are
there any benefits other than asset protection?
Yes, there are considerable benefits other than asset
protection, they are:
Family Management:
If a
family business, investment portfolio or investment real estate is placed in the
family’s LLC, the parents can give member interests to their children so the
children can actively participate in the activities of the LLC and receive
valuable financial training while the parents maintain control as the managing
members. Because the parents design
the LLC, they can make it last as long as they want so as to preserve family
property through the generations.
Valuation Planning for Estate and Gift Tax
Reductions:
Estate and gift taxes are calculated on the value of
the property owned by the decedent at the decedent’s death, estate taxes, and
on the value of the property received by the recipient of the gift, gift taxes.
Let’s say parent’s had investment real estate or securities with an
estate and gift tax value of $1,000,000. The
estate and gift tax law values property on what a willing buyer would pay a
willing seller for the item of property being valued.
However, if the parents place the $1,000,000 property in an LLC, then the
parents own interests in an LLC, not real estate or securities.
Let’s further assume that the parents gave each of three children an
interest in the LLC. The question
is, how much is a 1% interest in an LLC owning $1,000,000 worth of property.
Many people think it is worth 1% of $1,000,000, or $10,000.
However, remember if the willing buyer were to buy a 1% interest in the
LLC, the buyer would have to get the parents and the two other children to agree
to any major decisions. Because of
this obstacle, referred to as a minority or lack of control discount, the
willing buyer might only pay $7,500, meaning that the discount was 25%.
Suppose the surviving parents die owning 70% interest, having given the
other 30% away, rather than being worth $700,000, 70% of 1,000,000, the
interest, using our 25% discount, is only worth $525,000 ($700,000 x .75).
At a maximum estate tax rate of 55%, the LLC has saved $96,250.
This is a very popular estate and gift tax planning technique, and
discounts as high as 70% have been allowed by the Tax Court.
However, only
a qualified appraiser can determine the value of the LLC interests.
What
does the estate planning attorney do in an LLC engagement?
The estate planning attorney prepares the LLC
agreement in accordance with the parents’ desires and under the current estate
and gift tax drafting practices. The
estate planning attorney also files the necessary papers with the state agencies
that oversee the operations of LLCs.
What
does the client do?
The client has the most important task of all.
The client must follow the formalities of LLC operations so that the
Internal Revenue Service does not simply ignore the entity when valuing gifts or
estates. This means:
Distribution of Funds: If only the parents receive distributions from the LLC, the
Internal Revenue Service will disregard the entity because there has been no
change in control before and after formation of the entity.
This is why many clients prefer to create trusts for their children and
the trusts receive any distributions.
Scheduled Meetings: I advise my clients to schedule an annual meeting in my
office where all of the members are present.
We discuss the operations of the entity over the past year and I prepare
minutes the same as I would for a corporation.
It cannot be stressed strong enough that the formalities be followed.
File Annual Income Tax Returns: The LLC is a separate entity and is required to file its own
income tax return. The return is
filed as though the entity was a partnership.
Saving
Life Insurance from Estate Tax
What client might
need this technique?
Actually, any client that owns a
life insurance policy can benefit from an irrevocable life insurance trust (ILIT).
Some specific types are:
Clients
who will have taxable estates due to the life insurance proceeds.
Clients
who want to provide asset protection for the insurance proceeds for their
families and descendants.
Clients
who want to provide financial management for the insurance proceeds for their
family and descendants.
How do ILITs work?
An ILIT is an irrevocable trust that
is designed to be the owner and beneficiary of a life insurance policy on one
parent or a second-to-die policy that pays at the death of the last parent to
die. If a new policy is being
purchased, the client will transfer funds into the ILIT and the ILIT will apply
for a policy on the intended insured. If
an existing policy is transferred to an ILIT, the insured must survive at least
three years to have the policy proceeds protected from estate taxes.
As premiums are due, the insured transfers funds to the trustee of the
ILIT who holds the funds for a period of time and then pays the premiums.
Why does the
trustee hold the funds for a period of time?
Each person may make an annual gift
of $11,000, indexed for inflation, to any other person and there are no gift or
estate tax implications. However,
to qualify for the annual exclusion, the gift must be a “present interest”
gift. Present interest means that
the person receiving the gift must have a current right to the property or the
income from the property. For a
gift to a trust to qualify, the beneficiary must be given the right to demand a
portion of the gift. Because the
beneficiary of the ILIT has a right to demand a portion of the gift, the gift
qualifies for the annual exclusion. For
the demand right to be respected, the ability of the beneficiary to demand some
of the gift starts at the date of gift and for 30 days after the trustee
notifies the beneficiary of the right to demand.
That is why the trustee holds the funds for a period of time.
If the beneficiary
demands the money, how are the premiums paid?
It is generally intended that the
beneficiary not demand the funds, but there can be no such agreement.
It is important that the beneficiaries understand that their right to
demand is real, but that there economic interests are better served by having
the insurance in force.
How does the
client benefit from the ILIT?
Actually, the clients’ children
are the ones who really benefit. Assume
one client has a $1,000,000 life insurance policy and no other assets.
If that client names his or her spouse as the beneficiary and then dies,
the surviving spouse receives the $1,000,000 with no estate taxes paid because
of the Unlimited Marital Deduction. However,
the survivor will have a taxable estate and the children
will have to pay $125,250 in estate taxes.
However, if the $1,000,000 had been held in an ILIT, there would be no
estate taxes and the children would save $125,250.
As you can see, the benefits of an ILIT are significant.
What does the
estate planner do in these engagements?
The estate planner designs the ILIT
so as to accomplish the purposes of the clients. That means that the controls on the proceeds, the wording of
the demand rights and other details are included in the ILIT document that
accomplishes the clients’ goals and qualifies under the Internal Revenue
Service’s rules to avoid estate and gift tax problems.
What does the
client do in these engagements?
Initially, the client needs to
decide that they want to use an ILIT to protect their children and grandchildren
from needless estate taxes by purchasing, or transferring and existing policy,
their insurance in a properly designed ILIT.
Further, the clients must follow the formalities of the ILIT, such as
sending the demand notices, to avoid having the IRS ignore the ILIT and tax the
insurance proceeds as high as 55%
What client might
need this technique?
Family Limited Partnerships, or FLPs,
are frequently used by:
*Clients
who operate a business as a sole proprietorship
*Clients
who operate their business in the form of a general partnership
*Clients
who want to make gifts of property to their children but still control the
management or investment policies affecting the property
*Clients
with taxable estates
*Clients
who want some form of asset protection
*Clients
who want to protect life insurance proceeds from estate tax, but want more
flexibility than in an irrevocable life insurance trust
How do FLPs work?
The client and spouse form an FLP
and then transfer business or investment property to the FLP, each spouse, or
their living trust, then receives a 1% general partnership interest and 49%
limited partnership interests. The
property of the clients is now held in the FLP and the FLP interests are held in
the clients’ revocable living trust. The
spouses make all management decisions because they are the trustees of their
living trust.
How does the
client benefit from the FLP?
In many different
ways:
Estate and Gift
Taxes- Because of the way the partnership agreement is prepared, the total
value of the partnership interests is worth less than the property the
partnership holds. As an example,
if $1,000,000 in property is contributed to the FLP, the value of the
partnership interests might only be $600,000.
That means an immediate savings in gift or estate taxes.
Asset Protection-
The assets of the partnership are protected from lawsuits occurring at the
partner level because a creditor of a partner has no rights or access to
partnership property. This limit on
the creditor frequently results in a negotiated settlement on reasonable terms.
Property
Management- Because the parents retain control of the partnership in their
status as general partners, they can give limited partnership interests in the
partnership to their children and still control investment and management
decisions. This provides the
children with financial experience under their parents’ guidance.
What are the
clients’ responsibilities?
Typically, the client
follows the attorney’s instructions as to the necessary documents to create
and fund the partnership. The most
important responsibility for the client is to operate the partnership in
accordance with the formalities required by law and the partnership agreement
itself. Failure to do so may result
in the IRS’s ignoring the partnership and its many benefits to the client will
be lost. In addition, the client
must hire a qualified appraiser to value the property in the partnership and the
partnership interests themselves.
What are the
attorney’s responsibilities?
Aside from the preparation and
filing of the necessary documents to create and fund the partnership, the most
important duty of the attorney is to advise the client that the IRS is hostile
to their effectiveness and may audit the partnership and attempt to reduce the
estate and gift tax benefits, and that legal and accounting costs would be
incurred if such an audit occurred and the client wanted to fight the IRS.
Are limited
liability companies different?
Other than that no member of an LLC
is responsible for partnership liabilities, LLCs and FLPs are very similar.
