Estate Planning Focus - Spring 2002
Topics included in this issue:
By Mark B. Periard
Recent changes in federal tax law and by Michigan lawmakers have made college savings programs ("529 Plans") an even more favorable option for those investing in the Michigan Education Savings Program. College savings programs come in two forms: the prepaid tuition plan and college savings accounts ("CSAs"). Prepaid tuition plans restrict benefits available for out-of-state schools. CSAs, however, can be used at full value in any state and can be used for items other than tuition. The following is a summary of CSAs.
CSAs work like this: A donor makes contributions to an account which is established for the purpose of meeting higher education expenses of a designated beneficiary. "Qualified higher education expenses" includes tuition, room and board, fees, books, supplies and equipment required for enrollment or attendance. Undergraduate studies qualify, and some plans also include graduate studies.
The features of each state's CSA may differ depending upon the program adopted by that state. Most plans have the following features:
- Earnings build up income tax free.
- Distributions for qualified expenses are income tax free.
- Withdrawals for items other than qualified expenses are subject to a 10% penalty, and the earnings may be subject to income tax.
- Contributions must be made in cash.
- There are limitations on total contributions.
- Changes in investment options can be made annually.
- Contributions can be taken back by the donor, subject to a penalty.
- Donor may change the beneficiary of the account. If the new beneficiary is a member of the previous beneficiary's family, no gift tax will be incurred. A "member of the family" now includes first cousins.
- Donor can name a successor owner of the account.
- Amounts contributed are not included in the donor's estate upon the donor's death.
- Amounts contributed qualify for the $11,000 tax-free gift amount. A donor can front-load the account with 5 years' worth of annual exclusion gifts (requires a gift tax return to be filed).
Advantages of Michigan's Plan
Michigan has recently made the Michigan CSA program even more favorable than it had been.
- Maximum contributions for any one beneficiary were increased to $235,000.
- The Michigan penalty for unqualified withdrawals has been eliminated.
- Investment strategies may be changed once a year.
- Michigan residents who contribute to the Michigan plan are entitled to a state income tax credit on the first $5,000 contributed ($10,000 if by a married couple).
- TIAA-CREF is Michigan's investment manager and charges one of the lowest annual management fees (0.65%).
How to Compare Plans
Each state has its own rules and professional investment managers. Below is a checklist to assist you in reviewing the features of different plans.
- Are there state incentives to residents?
- Who is the plan's professional investment manager?
- What is his/her style, reputation, fee and performance?
- What investment options are available?
- Are there residency requirements?
- Is there creditor protection under the state's law?
- What are the contribution limits?
- Are there limits on how long assets can remain in the account?
- Are graduate education expenses permitted?
- Is there any restriction on the age of the beneficiary to open an account?
One additional new development is Upromise accounts. Individuals may register with upromise.com and earn cash back on purchases at designated retailers. The dollars earned are then contributed to a 529 plan account designated by the client. As of this date, amounts earned in this program cannot be contributed to Michigan CSA program accounts.
By Susan Gell Meyers
The rules regulating how quickly savings must be distributed from IRAs and qualified retirement plans have changed again, mostly for the better.
The IRS issued final regulations in April 2002 with a new uniform table for calculating minimum distributions from retirement accounts. For most participants, the new table reduces the amount that must be distributed to you or your beneficiaries.
If you have not taken your 2002 distribution and are interested in taking the minimum distribution possible, or if you would like to revisit who should be beneficiary of your plan for the greatest tax benefit possible, contact your WN&J attorney or our Web site to obtain the new uniform table or to discuss how the new rules impact you.
By John H. Martin
The family vacation home typically is a treasured asset. While it may not be the most valuable asset owned by Mom and Dad, it holds strong emotional and sentimental attachment for each parent and child. As parents grow older and children marry, having their own offspring, the transfer of the vacation home to the next generation becomes a difficult problem. The same problem may exist with undeveloped real estate that should be preserved for the next generation.
Should the cabin or cottage be given to the oldest child? to the one who lives closest? Can all the children be owners and possibly share its use? And, how and when should the transfer occur? Should Mom and Dad make a gift during lifetime? How can they do that and still enjoy the property whenever they want?
Frequently, parents want the vacation home to be available to all children and their families on some equitable basis. The challenge is to design a way in which this can occur. Formation of a limited liability company (LLC), with family members owning interests in the LLC, may be an excellent solution.
The Limited Liability Company Solution
A limited liability company is an entity formed to engage in some business activity. Here, the activity is the ownership and management of valuable real estate. Like a corporation, the liabilities of an LLC are limited to its assets. This means other assets of the owners are not at risk. For income tax purposes, however, the LLC is treated as if it were a partnership. Thus, the LLC is not a taxpaying entity, and all items of income and deduction pass through to the owners' individual tax returns.
The owners of an LLC are called members. Each holds whatever percentage interest he or she purchased or acquired by gift or inheritance. Management of an LLC may be by all of the members, voting by percentage interests. Alternatively, an LLC may be governed by one or more managers. Usually, a manager also is a member (owner).
If a manager form of LLC is used, decision making can be concentrated in fewer than all owners. This permits the transfer of ownership interests to other family members while maintaining control in one or only a few. Thus, Mom and Dad could name themselves as managers but transfer significant ownership interests to their children. By being managers, Mom and Dad retain the right to decide the use of the home, make repairs and improvements, and, in general, run the home as they always have done. At the same time, they may give significant portions of the value of the home to the next generation.
An LLC is created by filing Articles of Organization with the state in which it is formed (usually the physical location of the vacation home). The rules for governing the company are stated in a private agreement among all of the members, called an Operating Agreement.
Designing the Vacation Home LLC
Creation of a vacation home LLC requires answers to a number of questions. The following is a sketch of some of those issues that are addressed in an LLC Operating Agreement.
Managers. Who should be the manager(s)? Should a successor manager be identified? If multiple families own the property, should there always be a manager from each family?
Authority of Managers. In order to assure the smooth operation of the vacation home for the extended family, the managers need to be authorized to decide many details. Among them may be the authority to:
- Establish a schedule for use of the home (including use by the managers)
- Establish rules
- Arrange maintenance and repairs
- Establish annual membership dues (normally equal in amount per member)
- Levy special assessments (generally proportionate to percentage ownership interests)
- Establish usage fees (to reflect actual use of the property by members). The use of membership dues, special assessments and usage fees allows the managers to spread the financial burden among members in a manner that reflects differing amounts of use and differing percentage ownership interests. This promotes fairness between those who frequently use the property and those who are unable to enjoy it regularly.
Rights of Members. In a manager form of LLC, members have no voice in management, and they vote only on specified matters. The managers have complete control over normal operations. Members, however, may be given the right to vote on unusual events such as obtaining a mortgage for the property, leasing the property to a nonmember, selling the property and amending the Operating Agreement. Additionally, to provide a check and balance against an arbitrary manager, the members should be given the right to call a meeting to review the decisions of the manager.
Retaining Family Ownership. Frequently there is a concern that outsiders may become owners. This can be addressed by prohibiting the transfer of a membership interest to anyone not a descendant or a spouse of a descendant. Additionally, the members may be given the right to purchase an interest that goes outside the family as the result of a divorce.
Withdrawals. Things change. A child may move to the West Coast and be unable to use or be uninterested in the family cabin or cottage. Should he or she be permitted to withdraw and receive his or her share of the home's value? A withdrawal may place a definite financial burden on the remaining members. Generally, a balancing of interests must occur. Withdrawals may be permitted, but to discourage a withdrawal that is motivated primarily by the desire to cash in on inflated real estate values, the payout might be at a reduced value (e.g., 80% of market value) and be extended over several years (e.g., over 10 years at a low rate of interest).
Creating the LLC
It is fairly simple for the current owners of the family vacation home to create an LLC to hold the property. They file Articles of Organization with the state, carefully craft and sign an Operating Agreement, and transfer legal title to the home to the LLC. Each owner receives a percentage membership interest equivalent to his or her ownership before the LLC was drafted. If Mom and Dad now own the property jointly, each becomes the holder of a 50% membership interest. Presumably, each also would become a manager.
After formation of the LLC, the lifetime transfer of a membership interest to a child must occur within the framework of the federal gift tax law. The gifts can be structured, however, to give very favorable tax results. Mom and Dad each may give up to $10,000 per year to each other family member ($20,000 in total; also $20,000 even if only one makes the gift but the spouse consents to split gifts). Thus, if the gift is to come within this annual gift tax exclusion, it is likely that in each year only a small percentage interest can be given to each recipient. The small annual gifts become significant ownership percentages, however, if repeated over a number of years. As an alternative, Mom and Dad may decide to make gifts that exceed the value of the gift tax annual exclusion. The excess can apply against and use part of the lifetime gift tax exemption amount. That amount presently is a cumulative total of $1,000,000 for each donor.
When an annual exclusion or larger gift is made, the donor probably will want the gift to be a partial, minority interest of the entire property. This will yield the best tax result. A minority interest should be valued at substantially less than its proportionate share of the full value of the vacation property.
The value of a percentage interest gift is established in a two-step process. The first step is to value the company property, i.e., the vacation home (and a bank account or other assets owned in the LLC). This is done by obtaining an appraisal from a competent real estate appraiser. The second step is to value the fractional membership interest that constitutes the gift. This requires a second appraisal by a person qualified to value fractional interests in business entities. This second appraisal takes into account the facts that the asset is a minority interest, it lacks control, and little, if any, market exists for such an interest. The result of the second appraisal is likely to be a discounted value of 30% or more from the proportionate share of the total value. Thus, the membership interests typically can be transferred on a very favorable gift tax basis.
There may be other factors, such as local property laws, that need to be addressed in creating an effective vacation home LLC. In Michigan, for instance, the real estate tax assessment on the vacation home is a factor. Generally, a transfer of real estate will lift the cap on the assessment. For those who have owned real estate for many years, an uncapping may mean a noticeable increase in taxes. An exemption, however, may be available to prevent loss of the cap. For instance, the exemption for transfers among entities under common control (MCL 211.27a(7)(l)) may permit the conveyance of the vacation home into the limited liability company without adverse consequences. Subsequent gifts of membership interests can be made without the assessment being uncapped so long as no more than one-half of the original ownership is transferred.
Preserving the vacation home for future generations may seem a daunting task. There certainly are difficult issues to be addressed. A limited liability company, however, provides a vehicle that facilitates present gifts, retains management control and attains family objectives over the long term.
By Paul R. Jackson
Michigan recently enacted a Tax Amnesty Program that is available to both Michigan residents and nonresidents. The Amnesty Program allows taxpayers to pay delinquent taxes, correct errors in prior years' tax returns and repay invalid refunds with interest but without penalty or fear of prosecution for eligible Michigan taxes due prior to June 1, 2001.
Taxpayers will have to act quickly to take advantage of the Program. Applications for Tax Amnesty must be filed between May 15, 2002, and July 1, 2002 – a window of only 45 days.
If a taxpayer owes past-due Michigan taxes that are subject to the Amnesty Program but fails to take advantage of the Program, the state will assess a special 25% penalty in addition to any other taxes, interest and penalties that may otherwise be due.
The Amnesty Program is available for assessed and unassessed Michigan taxes including the estate tax; individual income tax; inheritance tax; sales, use and withholding taxes; the single business tax; and various other tax liabilities.
There are exceptions to eligibility for the Amnesty Program. The state will not waive criminal or civil liabilities if the tax is attributed to income derived from a criminal act, the taxpayer is under criminal investigation or currently involved in a civil action or criminal prosecution for that tax or the taxpayer has been convicted of a felony under the Revenue Act or the Internal Revenue Code. Moreover, taxpayers eligible for Michigan's voluntary disclosure program are not eligible for the Amnesty Program. Any application for the Amnesty Program that is found to be from a non-Michigan taxpayer qualifying for the voluntary disclosure program will be treated as a request for voluntary disclosure by the Department of Treasury.
To qualify for the Amnesty Program, a taxpayer must: (i) file a completed Tax Amnesty form with the Michigan Department of Treasury between May 15, 2002, and July 1, 2002; (ii) file original or amended returns if needed (you need not file a return if you are paying the entire tax and interest on an outstanding assessment); and (iii) remit payment for all tax and interest due, unless you qualify for an installment. The form for the Amnesty Program must be postmarked no later than July 1, 2002.
The Amnesty Program also applies to current tax assessments and taxpayers that are in either the hearing process or civil litigation if certain conditions are met.
We were saddened by the death of our friend and partner, Hal Schumacher, in April. Hal joined the Firm in 1953 after having worked as a Certified Public Accountant, a Special Agent for the FBI and a Tax Manager for Ernst & Young. For many years, Hal steered us through the financial straits of managing a law firm and was one of the founders of our Trusts and Estates Group. He was instrumental in creating the footprint for our practice today. Hal was the consummate counselor to clients and mentor to the Firm, serving as a role model for all who knew him. Hal's influence and presence will be greatly missed.
Estate Planning Focus
Editor: Susan Gell Meyers
Trusts & Estates Group Chairman: Mark K. Harder
Estate Planning Focus is published by Warner Norcross & Judd LLP to inform clients and friends of new developments. It is not intended as legal advice. If you need additional information on the topics in this issue, please contact your Warner Norcross attorney or any member of the Firm's Trusts and Estates Group.