A colleague of mine, who was named as executor under the will, is faced with the not uncommon circumstance of managing the two children heirs who don’t like each other. He can’t yet act for the estate, but there is the real possibility that things could escalate into an ugly and unfortunate situation. In these situations it is imperative that the executor consult with counsel before communicating with the children.
For example, the named executor may need to block access to the home if the children are indicating a fight over personal property is possible. A suggestion of a sharing arrangement might be advisable for a vacation rental property that both children want to access immediately. Instructions may need to be given to the officers of a family business, if a child indicates he or she may disrupt the operation of the business.
Of course, the named executor should endeavor to admit the will to probate as soon as legally possible. Babysitting disgruntled heirs is an occupational hazard of serving as executor. It also may be helpful if the will has a no contest clause.
Variable prepaid forward contracts (VPFC) are used to diversify a concentrated position in a publicly traded stock, and defer tax on the sale. Here is how they work: taxpayer (i) pledges the stock to a counterparty, (ii) receives cash equal to a percentage of the fair market value of the stock (typically 75-85% of the stock), and (iii) agrees to transfer to the counterparty cash or a variable number of shares of the stock at expiration of the contract. In Rev. Rul. 2003-7, http://www.unclefed.com/Tax-Bulls/2003/rr03-07.pdf, the IRS ruled that, since it was uncertain what the taxpayer would settle the contract with cash or a variable number of shares, the transaction could not be taxed until contract expiration based on the open transaction doctrine. Thus the taxpayer has use of cash during the contract period, but is not taxed until the contract expires.
VPFCs got a big boost from the Tax Court in McKelvey v. Commissioner recently, https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=11187. McKelvey involved a typical VPFC entered into by the founder of Monster Worldwide, Inc. in 2007. The IRS did not challenge the original VPFC. Instead what was at issue in McKelvey was whether an extension of the VPFC in 2008 was a taxable exchange. More interesting is that taxpayer died shortly after entering into the extension, which resulted in a step up in the basis of the Monster stock. Accordingly, since the stock had appreciated, income tax on the increase in the stock price would be permanently avoided. The IRS argued that the extension was a taxable exchange of the original VPFCs for new ones under Code Section 1001. The Tax Court disagreed holding that Code Section 1001 applies only to “property” and that the VPFCs were an “obligation” instead of property. The implications of McKelvey are fascinating…indefinite extension of VPFCs until death to obtain basis step up. The IRS has not yet indicated whether it will appeal.
VPFCs should be given consideration to someone with a concentrated stock position. Care must be exercised in structuring the VPFC. For example, coupling the VPFC with a lending transaction will cause the VPFC to be taxable, see Anschutz, http://www.ustaxcourt.gov/InOpHistoric/anschutz.TC.WPD.pdf. And, of course, the transaction costs of a VPFC can be substantial.
I was recently at Bandon Dunes Golf Resort, a great golfing experience. I have been there a few times, and every time the course and the weather present unique challenges. This time I was hit with cold, high wind and rain. I thought of my practice and the many issues that I face, often being hit from several different sides-tax considerations, charitable desires, economic realities or fears about the future and how to treat different children fairly. Those complexities make a particularly good golf analogy to the situation to which I was confronted on the 15th tee of Pacific Dunes-brutal wind into me but a bit from the left as well, pot bunkers to the right and left of me and gorse to the left of me. The solution is to stay steady and level, advice that holds for both estate planning and golf. We often want to lean forward and move faster, but that is only going to send us into the weeds.
Charitable remainder trusts (“CRTs”) are split interests trusts, with the taxpayer retaining an income interest and charity receiving the remainder. The CRT often is used to defer gain on the sale of highly appreciated property. The taxpayer receives an income deduction for the value of the remainder interest going to charity and defers the capital gain on the sale of the property until he or she receives distributions from the CRT. The administration of the CRT can be tricky, however, since the private foundation rules on self-dealing apply to a CRT.
The IRS recently issued PLRs 201713002 and 201713003 in which the IRS ruled that a CRT that qualifies under Code Section 664 as a charitable remainder trust so that a deduction is available but where the taxpayer fails to take the deduction is not subject to the self-dealing rules.
Since the income tax deduction typically is not significant, a client may be willing to forgo the deduction so that he or she is not subject to the onerous self-dealing rules while still achieving tax deferral. Forgoing the deduction could create estate and gift tax issues, and PLRs are not binding on anyone other that the taxpayer who sought and received the ruling. Still, the rulings are fascinating and present an interesting planning option to pursue with tax counsel.
Time to Lighten Up
With markets, both private and public, at all time highs, a lot of people are coming to me for ideas to mitigate the income tax hit of selling an appreciated asset. There are a number of charitable structures that a client may want to consider (i) charitable remainder trusts, (ii) donor advised funds, (iii) charitable lead trusts and (iv) pooled income funds.
Pooled Income Fund-What is it?
This post will introduce an old idea that is finding a new life, the pooled income fund (“PIF”). The concept of a PIF is quite simple. The client gives an appreciated asset to a PIF, the PIF sells the assets and invests the proceeds, and the client receives the income generated by the fund for life. PIFs have been around a long time, but, for various reasons, had gone out of favor. Recently, given the low interest rate environment, PIFs have made a comeback. Here is why.
Why is it Popular Again?
Given the low interest rate environment coupled with the rule that a PIF that is less than three years old can use the average of the last three years AFRs to calculate the charitable deduction means the charitable deduction for a PIF is substantially greater than a charitable remainder trust. This is because the deduction is for the value of the assets remaining at the end of the term, and using a low interest rate to determine that value means that the discount for time is smaller. When you couple this with the fact that most state laws allow the PIF to define income to include not only interest, dividends, rents and royalties, but also short and some long term capital gains, you have a very powerful income tax planning strategy. We are finding charities very interested in working with us to create these donor friendly PIFs.
A PIF can (i) produce an income tax deduction of 60-80% of the value of the substantially appreciated asset depending on the client’s age, (ii) avoid taxation of the sale of the substantially appreciated asset, and (iii) pay the client a lifetime income interest enhanced by a definition of income that includes some capital gain. If the client takes a bit of the tax savings and purchases an insurance policy to cover the amount passing to charity and mitigate the risk of a premature death, he or she has all the bases covered.
I generally don’t recommend structuring a business as an S corporation. Unlike LLCs and partnerships, the S corporation rules (i) restrict the number and type of owner, (ii) provide no flexibility in allocating income and loss, (iii) do not allow a step up of the assets at death of the shareholder and (iv) unlike other pass-through entities, the sale of assets and liquidation are both taxable events. This creates a sticky wicket to navigate.
Straight Stock Sale Tax Treatment Unlikely with S Corporations
A business sale can be structured as either a stock sale or a sale of the assets. Buyers like asset sales because they can pick and choose what they want, and they do not inherit the existing liabilities of the company. Sellers like stock sales because there is only one taxable event, rather than two. However, even if an S corporation shareholder is able to negotiate a stock sale, the tax code allows buyer and seller to elect to treat the sale as an asset sale by making a Section 338 election. Buyers like to do this because it allows them to step up the basis of the assets. In a simple sale for cash the 338 election often works fine. Assuming the asset sale results in a taxable gain. It is passed through to the seller and taxed, and the gain increases his basis in his stock, so the distribution of the sale proceeds, which is deemed a sale, results in no gain because the basis in the stock equals the cash distributed.
Earnouts and Contingent Payments Cause a Sticky Wicket
The problem is that most transactions are not straight stock for cash. Typically, a portion of the payments are made over time, and, when we introduce the installment sale rules to the mix, we find a huge disparity in tax treatment. It is possible to have a situation where the seller has a large gain in the year of sale, but not enough cash to pay the tax. That is a bad situation in its own right, but it can be made downright intolerable later when it turns out the seller reported too much gain in the year of sale, and only has a capital loss in later years that he cannot use. A lot of these problems can be mitigated by structuring all of the sale consideration as notes, but that introduces business risk to the seller that the notes do not get paid.
Given the sticky wicket discussed above, an S corporation shareholder contemplating the sale of his company needs to consult with counsel before he starts the sales process.
Given my experience with my mom, it is not surprising that the first topic I want to cover is who should be named trustee. The truth is that there is no single answer to that question, because trusts (which are simply vehicles where beneficiary ownership is separated from legal ownership) are created for many different reasons. The trustee, who holds legal title and owes the beneficiary a fiduciary duty to manage the assets held in the trust for the beneficiary’s benefit, can be an individual, an institution or even the beneficiary, depending on the purpose of the trust.
Many trusts are created to take advantage of spendthrift protection. In Texas, like most states, a trust created for a beneficiary other than the grantor (the person establishing the trust) provides some level of protection from the creditors (called spendthirft protection) of that beneficiary if someone other than the beneficiary is trustee or, if the beneficiary is trustee, the trustee is limited in making distributions to an “ascertainable standard.” The typical ascertainable standard is the “health, education, maintenance and support” of the beneficiary. Words matter here, and Texas is very strict. In Lehman v. United States, 448 F. 2d 1318(5th Cir. 1971) the court held that use of the word “comfort” along with support and maintenance was enough to negate an ascertainable standard.
Estate and Gift Taxes
Ascertainable standard is very important for estate and gift taxes as well. The IRS looks to state law to determine if an ascertainable standard exits, and, if it does, then it is possible for trust property to pass from one beneficiary to another without estate or gift tax consequences. So, for example, if dad creates a trust for his son for the son’s life and then to the son’s descendants , the trust property will escape estate taxes at the son’s death. Of course, the initial funding of the trust by dad is a gift, but that is a topic for another day.
Often trusts are created for estate tax savings where spendthrift protection is a secondary consideration.
May or Shall
As I said words matter here, and the use of the words “may” or “shall” before the distribution standard impacts the creditor protection significantly. Use of the word “may” means the distribution is discretionary. Use of the word “shall” means the distribution is mandatory. Of course, if the distribution is mandatory, it provides less creditor protection than if the distribution is discretionary.
Who is the Trustee
Finally, who the grantor names as trustee impacts the level of creditor protection. A trust naming the beneficiary as trustee with an ascertainable distribution standard will provide a modicum of creditor protection. A trust naming an independent person as trustee with a wholly discretionary distribution standard provides the highest level of creditor protection. Care should also be taken in selection of successor trustees or successor trustee selection methods.
Trusts are not one size fits all. You essentially start with a clean canvas. It is up to the attorney to carefully discuss with the client all options and objectives and inform the client about the benefits and risks of each option along the decision tree.
My dad was a banker, my mom a homemaker. Dad died of an aneurysm the morning after I graduated high school. His will left everything in a trust for mom’s benefit, with the bank as trustee. She was devastated over his loss, but also felt powerless, in part, because of the way dad structured things. He meant well and just wanted to take care of her, but it had the opposite effect. It would be years before she managed to come to terms with things.
I went on to college and played a little college golf, but soon realized I wasn’t good enough to make a career in the game. So I went to law school with the hope that I could help people avoid what happened to my mom.
Thirty plus years later, I have learned a lot about trusts, estates and income taxes. But more importantly I have learned how these areas of the law impact people. My hope in starting this blog is to share a little bit of what I have learned over the course of my legal career. And while I am at it I may have a thing or two to say about golf.
About Grady Dickens
I created this blog to comment on items of current interest regarding trusts, estate planning, charitable planning and tax law, and share my knowledge and over thirty years of experience as an attorney practicing in Dallas, Texas.