North Carolina Estate Planning Blog : North Carolina Estate Planning Lawyer & Attorney : Trust Counsel, PA : Trust Administration : Serving Chapel Hill, Durham, Raleigh, Pittsboro, Orange County, Chatham County

Based on what appeared to be a giant "loophole" in the gift tax law applying to gifts made in 2010, taxpayers could arguably make gifts to a wholly-owned grantor trust free from gift tax.  Last week at the Heckerling Estate Planning Institute, commentators said this was too good to be true, and opined that the IRS would soon close the loophole.  No sooner said than done:

Yesterday the IRS published Notice 2010-19, which applies to taxpayers making gifts in trust during 2010.  Under section 2511(c), a transfer of property to a non-wholly-owned grantor trust is a transfer by gift of the entire interest in the property.  To determine whether a transfer to a wholly-owned grantor trust constitutes a gift, the gift tax provisions in effect prior to 2010 apply.

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This is from Steve Akers' recent presentation, Estate Planning in Light of One-Year 'Repeal' of Estate and GST Tax in 2010:

"the Administration proposes to dramatically change the rules regarding valuation discounts (emphasis added). If there is an estate and gift tax reform package adopted next year, it could include that provision. If there is no legislation, there are indications that the IRS will issue regulations under §2704 that would place significant restrictions on valuation discounts on entities that are valued on the basis of their liquidation value (such as family limited partnerships holding marketable securities or other assets other than operating businesses.) Therefore, to have a chance to take advantage of the lower 35% rates in 2010 and to avoid the coming restrictions on valuation discounts, clients should consider make desired gifts and sales as early in the year as possible (Emphasis added).

Since the estate tax is sure to return, I am advising clients for whom a family limited liability company makes sense to form it now, and if possible use their $1 million lifetime gift tax exemption now to take advantage of discounting before it is legislated away.

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Many people are aware that they can give any number of other people up to $13,000 per year under the federal gift tax annual exclusion (IRC Section 2503(b)).  Staying under this number means that no gift tax return has to be filed and that there will be no reduction in the amount that can be passed free of estate taxes at the donor's death.

However, writing gift checks to children, grandchildren or others at the end of the year can cause the donee lose the benefit of the annual exclusion unless:

• The check was paid by the drawee bank when first presented for payment;
• The donor was alive when the check was paid by the drawee bank;
• The donor intended to make a gift and delivery of the check was unconditional; and
• The check was deposited, cashed or presented in the year for which completed gift treatment is sought and within a reasonable time after issuance.

Bottom line:  make sure your donee deposits the check no later than the last business day of the year.

Example: Bob gives his $13,000 gift check to his granddaughter Lucy on Christmas Day, 2009.  Lucy deposits the check in her bank on December 31, 2009.  The check is paid by the drawee bank on January 7, 2010.  This would be completed gift for Bob in 2009.

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Unlike in the income tax and asset protection arena, single member limited liability companies (LLCs) are not disregarded for gift tax purposes.    Pierre v. Commissioner, 133 T.C. No. 2 (Aug. 24, 2009). See Paul Caron's recent TaxProf Blog entry for a brief summary.

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This is from the latest edition of the GiftLaw eNewsletter:
 

Note from Greg:  Family Limited Partnerships (FLPs) were previously the preferred entity for obtaining discounts on transfers of wealth to younger family members.  FLPs have largely been replaced by Family Limited Liability Companies (FLLCs).  The writer of the article below often refers to FLPs even though the case involved FLLCs.

Indirect Gifts through FLP Trigger $1 Million Gift Tax

In David E. Heckerman et ux.v.United States; No. 2:08-cv-00211 (27 Jul 2009), the District Court determined that gifts of cash to an FLP together with gifts of FLP interests were indirect gifts valued at fair market value.

On November 28, 2001, David and Susan Heckerman created trusts for each of their two children, then ages five and two. They also created the Heckerman Family LLC and two solely-owned LLCs, Heckerman Investments LLC and Heckerman Real Estate LLC. Heckerman Investments LLC was designed to receive liquid securities and Heckerman Real Estate LLC was designed to hold realty.

On December 28, 2001, David and Susan Heckerman transferred a $2.05 million beach house in Malibu, California to Family LLC, with an immediate quitclaim deed to Real Estate LLC. On January 11, 2002, they transferred $2.85 million in mutual funds to Investments LLC and signed gift documents "effective on January 11, 2002" to transfer the majority of Family LLC units to the children's trusts.

Appraiser Mark Wellington of Private Valuations, Inc. completed an appraisal of the value of Family LLC units gifted to the children's trusts. He determined that the transfers would be subject to a 58% discount for lack of marketability. Therefore, both David and Susan had transferred a gift value of $1,022,000. Using their four annual exclusions (two parents times two children) and two $1 million gift exemptions, there was no gift tax payable.

The IRS audited the return, claimed that the securities transfer was an indirect gift and assessed gift tax of $511,497.56 for each donor. The Heckermans paid the gift tax and filed for a refund.

The IRS contended that under Reg. 25.2511-1(a), "whether the gift is direct or indirect," there is a transfer. Because the transfer to the FLP was completed on the same date as the gift of the units and there was no clear evidence that the transfer of the FLP units was after the funding of the FLP, the IRS claimed that this was an indirect gift. The IRS also claimed a step transaction.
The court supported both positions by the IRS. First, the gifts of FLP interests were apparently not signed until after January 11, 2002, but were "effective as of January 11, 2002." Therefore, the transfer process created an indirect gift on the theory that the children's trusts owned the FLP units when the cash was transferred.

In addition, following the rationale of Senda v. Commissioner, 433 F.3d 1044 (8th Cir. 2006), there was a "step transaction" that also created the indirect gift. Because the transfer of $2.85 million in cash to Investments LLC and the gifts of the LLC units were an "integrated transaction," the step transaction doctrine applied.

Editor's Note: It is significant that the IRS did not object to the FLP discounts for the transfer of the real estate on December 28, 2001 and gift of FLP units two weeks later on Jan. 11, 2002. With even a period of two weeks between the funding and the FLP unit gifts, the transfer was effective in producing a substantial FLP discount.
 

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Loans among family members, especially from parents to children, are very common.  However, most people are not aware of the tax laws regarding such loans.  With certain exceptions, if you make an interest free to loan to a family member (or friend, for that matter), the IRS will impute the interest income to you, meaning that you are required to pay tax on a certain amount of interest, even though you never received it.  Here are the basics:

• Loans of $10,000 or less.  No interest income will be imputed provided that the borrower does not use the money for income-producing investments.
• Loans of $100,000 or less.  No imputed interest income provided that the borrower has less than $1,000 of total net investment income each year.
• Other loans.  Make sure you charge (at least) the Applicable Federal Rate in place in the month during which the loan is made.  These rates, set by the government, change monthly and depend on the length of the loan [(1) up to 3 years, (2) 3 to 9 years, and (3) over 9 years)].
• Promissory Note.  Make sure you properly document the loan, with interest rate, payment terms and length of loan.  Otherwise the IRS may treat it as a gift, which would require a filing a gift tax return and possible payment of gift tax.  It also can help avoid family disputes in the event of the death of one of the parties to the loan.
• Deed of Trust/Mortgage.  To secure the payment of the loan by the borrower's personal residence, the borrower can sign a deed of trust, which is then filed in the county Register of Deeds.  The borrower can then deduct the interest payments for income tax purposes.
• See a Lawyer.  To ensure that you don't run afoul of tax laws and otherwise protect yourself, consult with a tax lawyer, and have him or her prepare the necessary documents.

 

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In the recent case of Estate of Valeria M. Miller v. Commissioner; T.C. Memo. 2009-119; No. 5207-07 (27 May 2009), the U.S. Tax Court allowed a 35% discount for gifts of family limited partnership interests.  No discount was permitted for the FLP interest owned by the decedent at her death.

This case shows that a properly planned and executed family limited partnership or limited liability company is still a very effective way to pass on wealth to younger generations.  However, Obama's tax proposals would do away with such discounts in most cases.

Click here for a summary and the full text of the case, thanks to NC State's GiftLaw eNewsletter.

 

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The U.S. Tax Court issued an opinion on January 29, 2009 in the Estate of Marjorie deGreeff Litchfield v. Commissioner (T.C. Memo. 2009-21).  The case involved the determination of appropriate (estate tax) discounts for built-in capital gains tax liabilities, and lack of control and lack of marketability for minority interests in two closely held family corporations, including one that had recently converted to a subchapter S corporation. The court allowed a discount of 91% for the built-in capital gains tax for the C corporation, and 52% for the S corporation.  The minority interest (lack of control) discount was determined to be 14.8% for the C corporation and 11.9% for the S corporation.  The lack of marketability discounts were established at 25% and 20%, respectively, for the two entities.  The FMV Valuation Alert offers a nice summary.

This case involved farmland and marketable securities.  Discounts for transfers of entities owning marketable securities and cash will be history if HR 436, the Certain Estate Tax Relief Act of 2009, passes.

 

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What is an LLC?

In 1977 Wyoming was the first state to enact laws permitting the creation of a Limited Liability Company. An LLC combines the best features of a corporation with the best features of a partnership. Among other things, an LLC has the limited liability of a corporation and the ease of management and flow-through income tax treatment of a partnership. 

In 2000, Wyoming again led the nation by enacting its Close LLC statute. This type of LLC is designed specifically for a small closely held family business. Family assets (such as stocks, bonds, farms, ranches, rental property, CDs and family businesses) can be managed under the protective umbrella of a Wyoming Close LLC.

Continue Reading...

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The IRS has announced many annual inflation adjustments for 2009, including an increase in the annual gift exclusion.

The annual gift tax exclusion for present interest gifts will be $13,000.

The annual exclusion for present interest gifts to a non-citizen spouse will be $133,000.

As I previously reported, North Carolina will no longer have a gift tax starting in 2009.

Click "Continue Reading" for the full text of Revenue Procedure 2008-66.

 

Continue Reading...

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The IRS recently published a report on lifetime wealth transfers in 2005 as disclosed to the IRS on federal gift tax returns.  The statistics are interesting to review - for tax and estate planning nerds, anyway.  The report also contains a history of the federal gift tax.  In 1924 the annual exclusion was only $500!

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In what comes as a surprise to me, based on the last news as reported in my postings in the last week or so, yesterday Governor Easley signed HB2436, which includes (page 201) a complete repeal of the North Carolina Gift Tax (Article 6 of Chapter 105 of General Statutes), effective January 1, 2009.

This will certainly make estate tax planning and Medicaid planning easier (and less expensive, in some cases) for North Carolinians.  I personally will miss the NC gift tax, since I enjoyed advising people about its peculiarities as compared to the federal gift tax.  After all, it it weren't for taxes, my job would be much less interesting!

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Yesterday the North Carolina General Assembly reached an agreement on the budget, but it did not include a repeal of the gift tax in 2009.  Instead, the repeal was put off until 2010.  However, given the state of the economy and continuing budget woes, I for one won't count on repeal until it actually takes place.

Most North Carolina residents and even many attorneys aren't even aware of the NC gift tax.  In my practice I have learned of many, many gifts that have been made over the years and not reported as required.

If the General Assembly ultimately decides to keep the gift tax, I believe they should provide funds to the Department of Revenue to hire me as a consultant!  I have a few ideas that would result in a marked increase in tax collected.

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My last entry was about SB1756, which includes a complete repeal of the North Carolina gift tax.  However, Governor Easley and others have been strongly urging the General Assembly to delete the repeal provisions.

If you would like to see the gift tax repealed, please email or call the office of your legislators and ask them to support repeal of the gift tax, effective 1/1/09. Go to www.ncleg.net and look under House Finance committee for names and email addresses of finance committee chairs.

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Budget negotiators for the North Carolina House and Senate agreed on tax breaks in the 2008-09 spending plan, which include, most notably for me and many of my clients, a repeal of the state gift tax.  North Carolina is one of only four states with a gift tax.  The others are Tennessee, Connecticut and Louisiana.

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As a proponent of Family Limited Liability Companies (LLCs) for asset management, creditor protection, and ease of gifting, I was pleased to read about the U.S. Tax Court's decision in Mirowski v. Commissioner, T.C. Memo 2008-74.  March 26, 2008.

Mrs. Mirowski, widow of the inventor of the heart defibrillator implant, created a trust for each of her three daughters in 1992, which were funded with portions of her interests in the patent licenses.  Then, in 2001, she formed a single member LLC, transferring substantial assets to it.  Shortly thereafter, Mrs. Mirowski gifted a 16% interest in the LLC to each of the trusts.  A mere four days later, she died unexpectedly.

The IRS argued under Section 2036(a) of the Internal Revenue Code that Mrs. Mirowski retained the right to income or enjoyment of the gifted property, so that it was included in her taxable estate.  The estate maintained that the Section 2038 "bona fide sale" exception applied, so that the transferred assets were not subject to estate tax.

The Tax Court agreed, holding that the LLC's activities do not have to be equivalent to those of a "business" for the bona fide sale exception to be applicable.  The Court stated that Mrs. Mirowski had "legitimate and significant  non-tax reasons" for establishing and funding the LLC, including 1) joint management of family assets, 2) combining family assets to maximize investment opportunities, and 3) enabling equal transfers to her daughters.

Some key points for Family LLCs to hold up for gift and estate tax purposes:

• Strictly follow the terms of the Operating Agreement
• State the reasons for the LLC in the Operating Agreement
• Have the Agreement reviewed by separate counsel for all initial members
• Leave enough assets outside the LLC to live on and pay taxes
• Don't mingle LLC assets with personal assets
• File the proper tax returns each year
• File the necessary documents with the Secretary of State each year
• Don't put your personal residence in a Family LLC
• Make sure the senior generation does not have the power to allocate profits and losses
• Require annual distributions
• Have the junior family members (or their trusts) make initial contributions to the LLC to provide for the pooling of assets
• Don't wait until the senior family member is near death

 The bottom line is that Family LLCs remain a viable and attractive option for transfers of family wealth, while also providing asset protection and management advantages.  Just make sure you use an attorney experienced in forming Family LLCs to assist you, and carefully follow all of his or her instructions. 

 

 

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Yesterday a public hearing on possible gift and estate tax reform was scheduled before the Senate Finance Committee.  Click "Continue Reading" for the full text of the report by the staff of the Joint Committee on Taxation.  I could not get the proper formatting to reproduce, so it's a bit difficult to read.

Of primary concern are potential limitations on Dynasty Trusts, discounts for Gifts of Interests in Family Limited Partnerships (and LLCs), and use of Crummy Withdrawal Powers in trusts (which allow use of the $12,000 annual gift tax exclusion for transfers to trusts).

Items for Immediate Consideration: 

1. Dynasty Trusts (page 33) - take action now to create or fully fund Dynasty Trusts.
2. Family Limited Partnerships (page 37) - those considering creating a Family Limited Partnership or  Limited Liability Company should do so now.  Those with existing entities should not delay making contemplated gifts of ownership interests. 
3. Crummy Powers (page 46) - fund Crummy trusts early in 2008 - review the three options.

By the way, the report references the "$11,000" annual gift tax exclusion, which is an error.  The exclusion was increased to $12,000 last year.

Continue Reading...

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The Revenue Laws Study Committee of the North Carolina General Assembly is taking a look at reforming the North Carolina Gift Tax.  I previously blogged about House Bill 235, describing the proposed changes.  In general the NC Gift Tax would be made similar to the federal gift tax, with a $1 million lifetime exemption.  The bill stalled last year, but is under study once again.

 

 

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The IRS has announced that it will soon propose new regulations governing 529 College Savings Plans, which will (I) contain an anti-abuse rule (to prevent using 529 Plans to skirt gift tax rules); (II) determine the estate, gift and GST tax results of contributions, transfers and withdrawals; and (III) create rules for making the 5 year election, address certain income tax issues, and create new record keeping requirements.

Here's the example the IRS gives as an abuse - quite a clever technique!:

Grandparents want to gift $1 million to a child without using any of their $1 million lifetime exclusion. So, the grandparents establish 529 Plan accounts for each of their 10 grandchildren, placing $120,000 in each (the $12,000 annual exclusion, times 2 for 2 grandparents, times 5 to use the 5 year averaging rule) times the number of grandchildren, and naming the child as the account owner. After the 5 years, the child designates a new beneficiary for each account, naming himself. Since Section 529 provides that no gift occurs if the new beneficiary is in the same family and at the same or a higher generational level, the grandparents have succeeded in giving the child $1.2 million without using any of their applicable exclusion.

The child would have to pay income tax and a penalty on any growth when withdrawals are used for non-educational expenses, but overall it would save the family a lot of tax.

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Family Limited Partnerships, or more commonly now, Family Limited Liability Companies, are great vehicles for management and protection of family businesses, real estate, and investments.  They also can be used to facilitate gifting, since interests in the entity given to junior family members typically qualify for minority interest and lack of marketability discounts.  These discounts can provide powerful leveraging. 

However, to stand up to IRS scrutiny, it is important the FLP or FLLC be properly formed and administered.  Click "Continue Reading" for a checklist to help determine if your family entity meets the necessary criteria.

 

Continue Reading...

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While non-citizens who reside in the U.S. are subject to U.S. income tax on their worldwide income, and U.S. estate tax for worldwide assets, they do not receive the same treatment as citizens when it comes to U.S. gift and estate taxes.  Thus, when one or both spouses in a married couple are not U.S. citizens, special planning may be required to avoid adverse tax consequences for transfers during lifetime or at death. Continue Reading...

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Gifting property can be an effective way to spend down assets for future Medicaid eligibility and to reduce estate tax liability. Many people are not aware, however, that unless an exclusion or exemption applies, one must file federal and state tax returns on all gifts of property. Failing to file returns and paying gift tax when required can result in hefty penalties and interest.   

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On February 15, 2007, bill H235 was introduced in the North Carolina General Assembly to reform the North Carolina gift tax so that it would be based on the federal gift tax.  Under the proposed legislation, NC gift tax would only be due if federal gift tax is due.  The change would be effective January 1, 2007.  Click "Continue Reading" to see the text of the bill.

Under current law, North Carolina allows the same $12,000 annual exclusions as the federal system, but rather than a $1 million lifetime exemption, there is only a $100,000 lifetime exemption, which applies only to ancestors and descendants.

The NC gift tax catches many residents (and even professional advisors) unaware, and many gifts are never reported, mainly because of ignorance of law, so the reform is probably a good idea.  I'm not sure how much tax revenue would be lost.

 

 

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I recently had a client come in who had made a gift of over $120,000 to her brother several years ago, using funds that had originally come from their mother.  She used the mother's accountant in Florida to prepare her gift tax return.  The accountant, apparently unaware that North Carolina had a gift tax, failed to prepare an NC gift tax return or advise her about the tax.

The North Carolina Department of Revenue, by checking the federal gift tax returns filed by NC residents, became aware of the federal return and contacted my client.  She now faces penalties and interest in addition to the tax due.

North Carolina allows the same $12,000 annual exclusions as the federal system, but rather than a $1 million lifetime exemption, there is only a $100,000 lifetime exemption, which applies only to ancestors and descendants.

I have seen other clients incur unexpected tax liability when their advisers were ignorant of NC gift tax laws.  If you are considering make any large gifts, make sure you seek qualified tax counsel so that you don't have any unpleasant surprises down the road.  The taxman will cometh!

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