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

As a proponent of Family Limited Liability Companies (LLCs) for asset management, creditor protection, and ease of gifting, I was please 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.

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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.

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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.

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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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