Topics included in this issue:
By W. Michael Van Haren
The Internal Revenue Service has so far lost its attempt to find a silver bullet that will pierce, for valuation purposes, a family limited partnership or family limited liability company ("FLP"). FLPs are formed to consolidate family investment assets, to provide a vehicle for gifting to children or grandchildren an asset that is not readily marketable, or for a variety of other reasons. Parents may retain control of the FLP as general partners or managing general partner. The Internal Revenue Service has litigated several cases in an attempt to ignore the FLP and value directly the assets in the partnership for gift or estate tax purposes. The courts will not ignore the FLP, except in situations where the taxpayer failed to honor the FLP. The IRS has found no silver bullet.
The IRS may appeal some cases, but all cases involving properly run FLPs have been taxpayer victories. The exceptions are FLPs where FLP and personal assets are not separated or when personal expenses are paid from the FLP. The range of discounts by the Tax Court has varied from 15% to 44%. The Tax Court will look to all the facts and circumstances in determining the value of the transferred interest. However, the Tax Court has made clear that it will carefully scrutinize the circumstances that gave rise to the FLP and the quality of the appraisal. In one case, the Court observed that it thought the government's appraiser was "over generous" to the taxpayer. The Tax Court's careful scrutiny gives hope to the IRS in its attempt to raise revenue on gifts or estates.
FLPs are here to stay. They remain an extremely viable and valuable tool in the estate planning context, perhaps more so in this age of uncertainty about the long-term prospects of our tax laws. As we go to press, Congress is considering tax proposals that call for the elimination of estate and gift taxes ten or eleven years from now. If one of those proposals becomes law, everyone's wealth remains exposed to transfer taxes during the phase-out period, and the uncertainty remains as to whether the laws will change before the repeal becomes effective. FLPs are an excellent strategy to both control one's assets and provide a hedge against taxation at death or when gifts are made of interest in the FLP.
On January 11, 2001, the IRS issued new rules for IRAs and qualified plans that generally reduce the required minimum distributions that must be paid to the participant of the plan each year. In addition, the new rules now permit most beneficiaries to take the IRA or plan benefits received on the death of a participant over the beneficiary's lifetime. These new rules apply immediately to IRAs, but apply to qualified plans only after the plan has been amended. Visit our Web site or contact your attorney at WN&J to obtain the new table for calculating your minimum distribution for 2001, or for more details on these important changes and how they may affect you.
Eliminating the death tax has received great attention lately. Critics of the tax claim it unfairly taxes dollars that have already been taxed, and it forces the sale of businesses and farms.
But repeal of the death tax involves much more than eliminating those claimed inequities. It involves the elimination of an entire wealth transfer tax system that supports certain social policies and coordinates estate, gift, generation-skipping and income taxes. It will not only eliminate $50 billion per year of federal wealth transfer taxes (the planned effect), but it will also eliminate over $5 billion per year of state wealth transfer taxes, billions of dollars for charity and substantial income tax revenue (the ripple effects). These ripple effects are likely to trigger new taxes. The new taxes will affect many more taxpayers than the wealthiest 2% that are currently subject to wealth transfer taxes. To-wit: the tax cut becomes a tax shift. Consider these examples:
- Loss of state tax revenues. Most states have replaced their separate death taxes with a "pickup" estate tax that effectively gives them a portion of federal estate taxes. Elimination of the federal death tax will eliminate state pickup taxes. It is estimated that states received approximately $5.5 billion from these taxes in 2000. Estimates show Michigan losing almost $200 million and Florida losing almost $800 million per year. States will need to generate replacement tax dollars for this loss of revenue. If, for example, Michigan returned to its old inheritance tax, then almost all Michigan estates would be taxed (not just those exceeding $675,000 after charitable and spousal transfers). Alternative revenue replacements would also likely apply to more than the wealthiest 2% of taxpayers.
- The loss of charitable contributions. The unlimited charitable deduction currently allowed against wealth transfer taxes creates a large incentive for charitable giving. Recent studies show that in 1998 the average charitable bequest from the largest 595 estates was $8 million; and in 1997 the average charitable bequest from the largest 182 estates was $41 million. Charitable contributions of this magnitude will substantially decrease without the tax incentives. David Joulfaian, a Treasury Department tax analyst, projects a combined $5 billion per year decline in charitable donations and bequests. This loss of charitable giving will substantially reduce the flow of nongovernment dollars available for the numerous educational, medical, scientific and other similar needs presently covered by charities. In turn, this will create greater demands for government spending in these areas, again requiring new sources of revenue. This revenue will also most likely be collected from more taxpayers than just the wealthiest 2% that are currently subject to wealth transfer taxes.
- Income tax changes and manipulations. One way to reduce the revenue lost from the repeal of death taxes involves a simple change in capital gains taxation. Currently, assets transferred at death get a step-up-in-basis which eliminates certain built-in capital gains that would otherwise apply upon a sale of those assets. By eliminating the step-up- in-basis rule (which is part of some repeal proposals), assets transferred at death would remain subject to large capital gains. This effectively creates taxation on all estates with appreciated assets, not just the wealthiest 2%. Additionally, the elimination of wealth transfer taxes will create new income tax avoidance techniques. For example, our current gift tax prevents substantial gifting to relatives in order to shift income to lower tax brackets. Use of techniques like this will decrease income tax revenue. The lost revenue will have to be replaced. Replacement revenues will be borne by more taxpayers than the wealthiest 2%.
- Repeal or reform. The above examples represent just three of the ways that the repeal of the death tax will evolve from a "tax cut" to a "tax shift." "Repeal" is clearly more complicated than simply wiping out a tax, and it will likely have a negative effect upon the majority of all taxpayers, especially those who are not currently subject to death taxes. "Reform," on the other hand, focuses on reducing rates and increasing exempt amounts. This option avoids many of the above problems and increases the likelihood of a "cut" instead of a "shift."
By Mark K. Harder
The heart of the West Michigan business community and economy is the family-owned business. These businesses range from small start-ups to billion dollar, worldwide enterprises.
Many families have successfully passed these businesses from one generation to the next. Less than a third of family-owned businesses, however, successfully pass to a second generation. Those that make it share a common trait: the owners made planning for succession of the business a priority in their business plan and family values.
When to Begin
Each succession plan is unique to the family and business involved, and this is reflected in how and when people begin the process. Ideally, planning begins when the senior generation is in its mid- to late fifties. This age frequently coincides with their children's becoming adults, making career choices, and beginning to demonstrate their ability to assume ownership and leadership roles. The senior generation is also generally in good health, so that the transfer is not unduly rushed.
Planning can begin earlier or later. But plans begun too soon may result in the senior generation's feeling "pushed out" or the younger generation's being given ownership and management responsibilities before they are ready to assume them.
Planning that is delayed until the senior generation is in its mid-sixties or later can result in a great many difficulties. Children who are in their forties and who see no firm plans for transfer of the business may become frustrated and leave the business for other opportunities. Delayed planning also can lead to a rushed transfer of ownership or management when unexpected health problems or death forces a rapid transition. Businesses run by family members in their seventies may lose out on the benefit of fresh thinking and ideas from the energy provided by new management or ownership. Delayed planning also can reduce the options available for a tax-efficient transfer.
How Long Will It Take?
Succession planning is a process, not an event, and involves several elements:
- A plan for transferring the ownership interests in the business
- A plan for transferring the management of the business
- A plan for addressing the financial security needs of the senior generation
- A plan for addressing income, gift, estate and generation-skipping taxes
- Strong family relationships
The amount of time it takes to prepare and implement a plan will vary from family to family and business to business. The amount of time required is proportional to the motivation of the family members to complete the process, the effort expended by them and the position from which they start the process.
If the senior generation has acquired sufficient assets outside the family business to support its income requirements in retirement, if sound management is in place to carry on the operation of the business and if healthy family dynamics exist, the development and implementation of a plan for the tax-advantaged transfer of ownership can be accomplished in as little as six to twelve months.
If, however, management is heavily dependent upon the senior generation, years may be needed to develop the management team needed to successfully carry on the business without the senior generation. Similarly, if there is disagreement among family members about who should step in the shoes of the senior generation, or the roles for family members in the business, the family will need additional time and perhaps outside advisers or consultants to work through these issues.
Development of a plan for succession of a business will take introspection and reflection, intrafamily dialogue and consultation with the family's business, legal and financial advisors. Six months or a year is not unusual or inappropriate for this stage. Once consensus among the family, owners and management is reached about the objectives, strategies and action steps, implementation of the plan can proceed. In some cases, where a sale to family members is involved, the succession can occur in a matter of months. In cases where the plan involves more elaborate transfer strategies, grooming another generation of management or financial planning for the senior generation, implementation of the plan will play out over a period of years.
Planning for the succession of the management and ownership of the business is one of the most important strategic planning activities in which a family business can engage. For families who seek to transfer their business to the next generation, the hardest step is the first one. Although starting the process may be difficult, the benefits of doing so are many, and beginning the process early and proceeding diligently is essential for a successful continuation of the business.
On January 9, 2001, the IRS issued interim guidance changing the rules that have governed equity split dollar agreements since 1964. The interim guidance currently applies to all equity split dollar arrangements, and prior agreements have not specifically been grandfathered.
Under the old rules, the IRS had treated the economic benefit to the employee under an equity split dollar agreement as income. The economic benefit was defined as the value of life insurance protection, as measured by the insurer's published premium rates for one-year term insurance (PS-58 rates). The employee was taxed to the extent that the rate exceeded the employee's share of premium payments.
As of January 9, 2001, the IRS has discarded this traditional theory of taxation and indicates that the equity buildup in a policy will be taxable to the employee, in addition to the PS-58 differential. The IRS set forth two new theories of taxation and measurement of the economic benefit, based on the terms of the agreement and the actual practice of the parties. The economic benefit to the employee can be: (1) measured by the employer's premium payments and taxed as an interest-free loan, or (2) measured by the value of the life insurance protection, any dividends paid on the policy and the difference between the cash surrender value and the employee's premium payments, all taxed as compensation income under IRC Sections 61 or 83.
The IRS has discarded the PS-58 rates as the proper measurement of the value of life insurance protection after December 31, 2001, and failed to give clear guidance as to how to properly measure the benefit thereafter. The IRS will issue final guidance after it has considered public comments. Until final guidance is rendered, however, the tax status of split dollar agreements remains uncertain.
Estate Planning Focus
Editor: Susan Gell Meyers
Trusts & Estates Group Chairman: Mark K. Harder
Estate Planning Focus is published semi-annually in the spring and fall 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.