Total Return Investing and the Marital Deduction Trust

Title: "WHEN THE TREE CAN BECOME PART OF THE FRUIT"

Publication Date: October 2001

Author(s): Michael W. Rosenberg

"WHEN THE TREE CAN BECOME PART OF THE FRUIT"

The grafting of total return investing mandated
by the Uniform Prudent Investor Act 
onto marital deduction trust requirements
for annual distributions of all 
income to the surviving spouse

A fundamental concept of a trust is the creation of two different classes of persons (or entities) that will receive distributions from the trust. These classes are designated as the beneficiaries. The residual beneficiary (or beneficiaries) receives the assets upon the termination of the trust. Prior to termination, distributions are made to an income beneficiary (or beneficiaries). There may be one or more levels of income beneficiaries, i.e., to the spouse, upon death of spouse, to children until age 50 and distribution to grandchildren. The spouse and the children are the income beneficiaries and the grandchildren are the residual beneficiaries. The income beneficiary is usually limited to the receipt of income and the principal is held for eventual distribution to the residual beneficiary. Therefore, in a traditional investment framework, the trustee would seek to preserve the principal and invest the principal to generate a reasonable annual receipt of income. In the traditional investment milieu, growth of principal was not a goal especially if a growth investment program reduced annual income. The product of growth investment yields capital gains. As described below, capital gains have historically always been allocated to principal.

The principal thrust of this article is to examine total return investing with the marital deduction trust (a "MDT") held for the benefit of the surviving spouse during the remainder of the life of the surviving spouse. The surviving spouse like any other income beneficiary has an interest in a MDT only for the duration of the life of the surviving spouse. This interest requires that all the income must be paid to, or for the benefit of the surviving spouse on an annual basis.

Since this article is written in the fall and I have recently journeyed to the Eucker Orchard Store on the square in Hartford for Jonadels and cider, it is appropriate to use the analogy of an apple tree. An apple tree produces an annual crop which is picked. The tree endures (discounting termites, fires, diseases, and other casualty events). Over the span of years, some branches are pruned and new branches grow and the tree itself, can increase in size. In trust terms, the annual harvest of crops is the fruit which is distributed to the income beneficiary. The tree remains and upon the termination of the Trust, the residual beneficiary will acquire the tree.

What is trust income? For trust accounting purposes neither the Internal Revenue Code, nor the Treasury Regulations promulgated under §643 which otherwise provides definitions of items which are relative to trust accounting, has ever defined income. Other terms which describe a form of income (i.e., distributable net income) have been long defined. In turn, the Regulations have clearly stated that income is governed by the law of the state in which the trust maintains its situs. The Regulations as they currently exist and as are proposed will not modify one basic concept. A trust instrument cannot turn traditional concepts upside down. The clearest example is to call what would normally be income as capital gains and vice versa. The Regulations have always granted the power to the IRS to disregard such classifications and revert back to the traditional concepts.

Ohio, like all other states, has long had a Principal and Income Act. Although there are more than 10 categories which are addressed by the Ohio Principal and Income Act, the easiest distinction to apply on a broad basis is the difference between dividends and capital gains. If the trust owned 100 shares of GE, the annual cash dividend paid by GE to shareholders has always been income. In the MDT arena, the cash dividend always must be distributed to the surviving spouse. If there is a GE share dividend or share split the additional shares received by the trust represent additional branches on the tree. They are part of principal and remain in the trust. Conversely, if the trustee would sell the 100 shares and make a profit of $5,000 on the sale all the following occur from a tax accounting standpoint.

1. The $5,000 profit is a profit of the trust. The trust pays the capital gain tax on the sale.

2. The proceeds from the sale of the GE stock after payment of the tax are reinvested by the trustee. These total proceeds then become a new tree and the GE tree no longer exists.

This fundamental method of separating the fruit from the tree has abided without modification. In the past several years and with respect to Ohio in 1999 the standard for investment by fiduciaries was radically changed through the enactment of the Uniform Prudent Investor Act ("UPIA"). A more extensive discussion of the UPIA can be found in Uniform Prudent Investor Act title in this Recent Development section of the web site. From the trust accounting standpoint, the emphasis now is on total return of assets over a period of time. The great majority of that total return will normally be achieved through both realized (capital gains on assets sold) and unrealized appreciation in the value of equity shares of public companies or shares in mutual funds.

If a fiduciary is now required by reason of the UPIA to diversify, take risk and invest for total return, does this create a conflict with requirement to pay all income under a MDT to a surviving spouse? As part of the preamble to the Proposed Regulations the Internal Revenue Service poses the question with regard to a MDT as follows:

"In addition, trusts that qualify for the gift or estate tax marital deduction must pay to the spouse all the income from the property. All the income is considered paid to the spouse if the effect of the trust is to give the spouse substantially that degree of beneficial enjoyment of the trust property that the principles of trust law accord to a person who is unqualifiedly designated as the life beneficiary of a trust. Section 25.2523(e)-1(f) of the gift tax regulations §20.2056(b)-5(f) of the estate tax regulations."

At the present time there is a catch in the entire process. The stand taken by the IRS is in the form of proposed Regulations. However, the proposed Regulation clearly states that the Regulation will not become effective until it has been promulgated in final form. The comment period has expired and hearings were held on the proposed Regulations during the past summer. There is no reason to expect that the proposed Regulation will not become final. However, the effective date cannot now be determined.

The Internal Revenue Service, in my opinion, has taken a very forward looking approach through the promulgation on February 15, 2001 of Proposed Regulations. The Proposed Regulations while still permitting states to define income, will allow a MDT to take a number of approaches to distributions which would be made to the surviving spouse assuming that the enabling state legislation has been appropriately modified. The tactic of the IRS is a form of push-pull. If a state changes its Principal and Income Act to embrace the concept of total return, in turn the Internal Revenue Code will recognize distributions which are made under a total return statute to constitute income and therefore meet the requirements of §2056 for distributions to a surviving spouse.

Several states have already taken the second step. The first revision of a state's Principal and Income Act following the promulgation of the Proposed Regulations by the Internal Revenue Service occurred in Delaware effective as of June 15, 2001. Dallas Woodall, a long time member of the appropriate committee of the Ohio State Bar Association advises that a sub-committee has been formed and is engaged in the review process of the revision of the Uniform and Principal Income Act. The September/October 2001 edition of the Probate Law Journal of Ohio contains an article authored from the perspective of the banking industry. The author, a vice president of Key Bank opines that the Ohio Bankers Association will sponsor the legislation when the issue of the flexibility of a trustee to adjust between principal and income is resolved. Did Ohio proceed in the wrong order by holding fiduciaries to a test of total return before changing the definition of income to take into consideration total return?

One aspect of total return is very familiar to tax planners. Since the enactment of the Tax Reform Act of 1969, there are two and only two statute complying methods of making distributions from a charitable split interest trust. A charitable split interest trust is an instrument that provides either a distribution of income for a stated period of years or a life of one or more persons in one of two forms. Either the charitable institution receives the income and upon the expiration of a period of years the assets in the trust are distributed to individuals. Alternatively, individuals receive income for the stated period of years or until a designated event (i.e., death) and at the expiration of that time the assets are distributed to a charity. The amount of income distribution in each year would either be an annuity or a unitrust payment. An annuity is a distribution equal to stated percentage of the fair market value of the assets at the time of the original transfer of property to the trust. The dollar amount is fixed for the duration of the payment period. A unitrust payment for the following year is a stated percentage of the fair market value of the assets determined as of the last day of the current year. The unitrust payment will fluctuate in each year dependent upon the value of the assets. Value for the purposes of determination of each unitrust payment takes into consideration realized capital gains (and losses) and unrealized appreciation (or depreciation) represented by the fluctuation in quotes for securities. Only the unitrust alternative is pertinent to the balance of this article.

A unitrust payment is to be compared with payments which are made to a surviving spouse under an estate planning document which seeks to qualify as a MDT. Any trust held for the benefit of the surviving spouse must require that all of the "income" of the trust must be distributed to or for the benefit of the surviving spouse in each year. This requirement is further amplified to extend the income paying period measured from the date of death of the taxpayer through the date of death of the surviving spouse.

What is the relationship between requirements for charitable split interest trusts and a MDT? One of the methods of total return allowed under the Proposed Regulations is a unitrust payment. The alternative contained in the Proposed Regulations include a number of variations. These include the following:

1. The closest analogy to a charitable split interest trust is the creation of a functional equivalent of a unitrust payment. The proposed Regulations speak in terms of a definition of income to be between 3% and 5% of Trust Asset value. The taxpayer at the time of the creation of the instrument would have the authority to establish the right of payout which is tied to asset value. Although not discussed in the Proposed Regulations, establishing this range of payout does have similarities in other areas. The historic dividend rate for the companies which comprise the Dow Jones Industrial Index when added to the historic dividend rate of shares of companies which comprise the Dow Jones Utility Index would yield an annual return at the lower end of the range. The high end of the range is the amount of income which must be distributed by any §501(c)(3) organization which is a private foundation in support of its exempt purposes in order to avoid the imposition of excise taxes. If total return is more than 5% adopting a unitrust approach for distribution from a MDT more likely than not would result in a growth of the tree since all of the fruit would not be required to be distributed. By way of example, the historic annual value over a 50 year period of the S&P 500 stock index has been almost 11%.

2. Total return would now also include realized capital gains. The trustee would have the discretion to distribute capital gains or retain them. The theory behind this approach is the desire to permit the Trustee to make an equitable adjustment between income and principal if necessary to insure that both the income beneficiary and the remainder beneficiaries are treated impartially based on what is fair or reasonable to all beneficiaries. This is the area examined by the article in the Probate Law Journal of Ohio.

The proposed Regulations contemplate that there could be three different methods of addressing treatment of capital gains. In the first instance the applicable state law could have an ordering rule. An ordering rule provides that in determining a unitrust amount the following items are applied by the trustee in determining the taxable income of the Trust. The taxable income of the Trust is generally total income of the Trust less the distributable net income. The distributable net income is the amount of income actually distributed or the amount which is required to be distributed, whichever is greater. An ordering rule could provide that in determining the unitrust amount the following categories of income are the components of the unitrust amount; (a) ordinary income (dividends and interest); (b) short term capital gain (proceeds from sale of an asset held for less than one year); (c) long term capital gain (proceeds from sale of an asset held for more than one year); and (d) return of principal. If the state law does not include an ordering provision, the trust instrument could address the statutory gap by providing its own ordering procedure. Lastly, if neither state law, nor the trust instrument has an ordering provision, the decision could be left to the discretion of the trustee. At this point, the trustee makes a determination. The trustee must follow a regular practice of treatment of capital gains to the extent that the unitrust amount exceeds trust ordinary income. The decision once made by the trustee must be consistently followed with respect to all realized capital gains. The choice is to treat capital gains as part of distributable income and therefore taxed to the beneficiary to the extent received or alternatively to not consider capital gains as part of distributable net income with the result that the trust pays the full tax on the capital gain. The Proposed Regulations clearly state that either method followed by the trustee is a "reasonable exercise of trustee's discretion".

What form will Ohio law take? The language which is contained in the Proposed Regulation §1.643(b)-1 which is titled, "definition of income" in pertinent parts reads as follows:

"...income, when not proceeded by... means the amount of income of an estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Trust provisions that depart fundamentally from traditional principles of income and principal, that is, allocating ordinary income to income and capital gains to principal, will generally not be recognized. However, amounts allocated between income and principal pursuant to applicable local law will be respected if local law provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust for the year, including ordinary income, capital gains and depreciation. For example, a state law that provides for the income beneficiary to receive each year a unitrust amount of between 3% and 5% of the annual fair market value of the trust assets is a reasonable apportionment of the total return of the trust. Similarly, a state law that permits the trustee to make equitable adjustments between income and principal to fulfill the trustees duty of the impartiality between the income and remaining beneficiaries as generally a reasonable apportionment of the total return of the trust. These adjustments are permitted when the trustee invests and manages the trust assets under the state's prudent investor standard, the trust describes the amount that shall or must be distributed to a beneficiary by referring to the trust income and the trustee after applying the state statutory rules regarding allocation of income and principal is unable to administer the trust impartially. In addition, allocation of capital gains to income will be respected if the allocation is made either pursuant to the term of the governing instrument and local law, or pursuant to a reasonable and consistent exercise of a discretionary power granted to the fiduciary by local law or by the governing instrument, if not inconsistent with local law."

A new day is dawning. Two events must occur. The Proposed Regulations must become final. Secondly, the Ohio Principal and Income Act must be amended. When these events occur a review of all existing trusts will be appropriate.

There is an ancillary concern. Almost all current trusts are written to provide for distribution of income and discretionary distributions of principal. If there is a universal theme which is expressed by any spouse in the planning discussions which accompany the establishment of a MDT is the expressed immense distaste of a spouse being required to make a request to a trustee for distributions in addition to income. This distaste applies whether the trustee is a family member or a trust company. Often formed is the following question; "why should I have to go to someone else to request a distribution beyond income from the money that my spouse and I created during the period of our marriage?" When discretionary distributions of principal are allowed the adoption of a unitrust definition of income does not completely alleviate that concern. Even if Ohio amends its principal and income act and the Proposed Regulations become final in order to provide maximum flexibility, instruments will probably still be drawn to allow discretionary distribution of principal for "health, maintenance, education and support". 

Gifts of Non-Publicly Traded Shares

Title: When Slicing a Few Potatoes (as opposed to onions) Can Cause Tears

Publication Date: October 1999 - Revised September 2001

Author(s): Michael W. Rosenberg

WHEN SLICING A FEW POTATOES (AS OPPOSED TO ONIONS) CAN CAUSE TEARS

Valuation is an extremely important tool in estate planning. The most volatile area is determining the value of minority interests in closely held non-public entities. It is universally recognized that a substantial discount can be secured for valuation purposes when the particular asset consists of a minority interest. This discount is recognized as a result of the lack of marketability of the security, ("Marketability Discount"). This same factor is also described as the lack of liquidity. For any reader who has been engaged in estate planning discussions with this office we have always suggested a 30% Marketability Discount. The Marketability Discount is fundamental to an ongoing giving program and the valuation of assets in the estate of a decedent. When framed within the environment of per-donee annual gifts, the Marketability Discount has been illustrated in prior discussions of its leveraging effect to allow a gift of approximately $14,000 in real value to a gift tax valuation of $10,000.

Valuation becomes doubly difficult when the subject matter of the valuation is a share in a non-publicly traded company. In this instance there are two steps. The first is to value the company. The second is to then determine the Marketability Discount for minority interests. A third complication arises when the equity interests of the company that is being valued is divided into more than one class of stock. A correlative to the Marketability Discount is a second discount for lack of control (the "Control Discount").

If there is a Control Discount then the opposite must be true. A premium would be paid for control (the "Control Premium"). This flows from the premise that the value of the company is X. If the minority interest is a percentage of X and reduced by a Control Discount, the other half of the equation must mean that the owners of the interests that do have control value their interest in X as a percentage plus a premium. The sum of the parts must equal the whole. To use an analogy of trading of options is that valuation of a company is a 0 sum game. Whatever is lost in one part is gained by the other parts so that the total is equal to the sum of the parts. Control takes two forms, absolute control or the right with others to make the determining decisions.

This article was first written in October, 1999, following the decision of the United States Tax Court in the Estate of Richard R. Simplot, 112 TC 130 (1999). The decision of the Tax Court has been reversed and remanded by the 9th Circuit Court of Appeals. The decedent at the time of his death was one of four children of the legendary J.R. Simplot who probably was the first billionaire living in Idaho. The J.R. Simplot Company (the "Company") is most widely known as the largest purveyor of potato products to McDonald's. J.R. Simplot was personally an enthusiastic backer of Micron Technology ("Micron") based in Boise which has been the second largest U.S. maker to Intel of computer chips. The Company owned over 5 million shares of Micron as of the valuation date. The Company was begun more than 40 years ago and has always been privately held. As of the date of the death of the decedent, he and his three siblings owned all the voting shares. The non-voting shares were owned by these same individuals together with various trusts for the benefit of their families. In addition, an Employee Stock Ownership Plan (an "ESOP") owned a 3.6% interest in the non-voting stock.

The principal issue before the Tax Court was the valuation of the shares of the Company owned by the decedent. The decedent owned 18 of 76.445 shares of voting stock and 3942.048 of 141,288.58 shares of the non-voting stock. Consistent with family practice, all of the voting shares and so many of the non-voting shares as would total $600,000 in the aggregate of the Company were distributed to a credit shelter trust for the benefit of the spouse of the decedent and the children of the decedent. The balance of the estate was given outright to the spouse of the decedent. The succession taxes would be paid by the spouse. In a perfect world if the value of the shares was less than the credit shelter amount then in effect ($600,000) the balance of the estate would have qualified for the full marital deduction except for the taxes paid.

The valuation of the shares for the estate when the estate tax return was filed was performed by Morgan Stanley. Although Morgan Stanley stumbled in the process and was pilloried by the Tax Court, its approach was ultimately vindicated by the decision of the Court of Appeals. An aside is appropriate. For those of you who are not familiar with requirements for an ESOP, both contributions to an ESOP and purchases and sales by an ESOP must be at fair market value. When the shares of the Company are not publicly traded this requires an annual valuation process by an outside independent third party. The Company had used Morgan Stanley for this purpose for a number of years. Accordingly, it was altogether appropriate that the estate would hire Morgan Stanley to value the shares of the decedent for the purposes of the federal estate tax return.

When the return was filed, Morgan Stanley had valued both the voting shares (the "Class A shares") and the non-voting shares (the "Class B shares") at the same figure of $2650 per share. By the time that the case moved to trial Morgan Stanley recognized that it had created a fundamental error in counting as issued and outstanding shares held in the Company. Once this egg was wiped off the face of Morgan Stanley, its valuation was increased from $2650 per share to $3025 per share. Therefore, before the first gun was fired, the estate was already reeling from a $1,500,000 punch because Morgan Stanley could not count. Ultimately, the Court of Appeals (by a 2 to 1 decision over the strong dissent of Judge Fletcher) accepted the original approach of Morgan Stanley and the position advocated by the Estate before the Tax Court.

The Internal Revenue Service was underwhelmed by this valuation and when it issued its notice of deficiency three years after the filing of the return, it asserted that the Class A shares should be $801,994.83 per share and the non-voting shares should be increased to $3585.50 per share. After the trial and in submission of its brief, the Internal Revenue Service reduced its valuation for the total Class A shares from more than $14 million to $11 million and a corresponding reduction of approximately $300,000 in the Class B shares to $13,887,000. The decision of the Tax Court can be predicted by any one. It selected a value which was higher than that of the estate and lower than that advanced by the Internal Revenue Service. The reason that this whole study is being prepared is threefold; to examine the approach taken by the Tax Court in first valuing the Company itself, secondly, that a premium (which is small in percentage but significant in dollars) was applied to the Class A shares for voting privileges (the "Voting Premium") and thirdly, that the Tax Court allowed Marketability Discounts on both shares but in differing percentages.

Consistent with the Morgan Stanley approach, the Estate believed that the valuation matter before the Tax Court was one item lumping the voting and the non-voting shares together and, thereby, no Voting Premium would exist. The Internal Revenue Service in the Notice of Deficiency had separated the two. As discussed below this was the solution of the Tax Court as reflected in its opinion. The Estate had asserted that since the voting shares did not represent voting control they were effectively equivalent to non-voting shares, thus, neither Control Premium, nor Voting Premium The Internal Revenue Service argued and the Tax Court agreed that a Voting Premium should be given to the voting shares. The Court of Appeals agreed in appropriate circumstances a Control Premium can exist. It determined that application of a Control Premium to the shares by the Estate was inappropriate because the Estate owned a minority interest and therefore could not derive any economics benefit from ownership of voting shares. The absence of an economic benefit to be derived equated to the non-existence of a Voting Premium. In determining whether or not a Voting Premium existed, the Court of Appeals limited itself to a consideration of three items; ability to elect a director, distributions upon liquidation and equality of dividends. The Court concluded that since the voting shares owned by the Estate did not guarantee election to the Board, each share would receive equal dividend distributions and the non-voting shares would receive a slightly higher disproportionate share of proceeds in the event of liquidation, no economic benefit would flow to the voting shares of the Estate. The analysis could not be the same for an Ohio corporation which by law employs cumulative voting for directors when the board consists of 8 members and one shareholder owns greater than 22% of the shares. Apparently no one advanced the argument that in a family business share ownership leads to employment, salary, benefits, perquisites, etc. At comparable levels for the same class of members, i.e., Richard and his siblings and/or spouses all would have been executives, positions would be provided for children and/or spouses of children who wished to work for the family business. This certainly is a substantial economic benefit and one that occurs in the overwhelming majority of family businesses.

One aspect of the Tax Court opinion that survives the reversal in the 9th Circuit is the concept of equity value. Before the Court of Appeals, both the Estate and the IRS agreed that the total value of the company on the date of death was the value concluded by the Tax Court as after it formulated and applied equity value to the Company.

In determining the equity value an enterprise value was developed plus cash and minus debt. Furthermore to derive the enterprise value of the company the investment in Micron was not used to originally value the Company. The enterprise value was calculated on both an income and market approach. After the value of the Company exclusive of Micron was derived, then the value of Micron was added to the average of the values determined for the Company under the income and market approaches. Micron was valued at its trading value less the federal and state income taxes payable on the paper profit of the Company. The Tax Court specifically states that this definition of "equity value" is different from equity value determined in accordance with generally accepted accounting principles which would be book value of assets less liabilities.

The opinion of the Tax Court torturously works its way through the following process with the appropriate citations furnished at length in the opinion.

1. The statement of the Treasury Regulation that for valuing assets the fair market value is the appropriate standard with utilization of the hypothetical willing buyer and willing seller and each of whom would seek to maximize his or her profit from any transaction involving the property. The Court of Appeals emphasized that this occurs on the date of death or the alternate valuation date if alternate valuation is selected.

2. Valuation of property for tax purposes is a question of fact involving an examination of all facts and circumstances on the date of valuation without regard to hindsight but taking into consideration future events that were reasonable foreseeable on the valuation date can be considered. At this point, the Court of Appeals stated that the Tax Court made two fundamental errors. The first was valuing all the voting shares outstanding instead of the number of shares owned by the Estate. The second was improperly focusing on particular, imagined possible purchasers and unfounded supposition that value attributable to a block of shares also attached to each fraction.

3. The actual arms length sale of unlisted stock in the normal course of business within reasonable time before or after the valuation date is the best evidence of fair market value. When there are no such sales the Court often looks to the value of publicly traded stock of corporations engaged in similar lines of business with the factors of valuing stock in a closely held corporation including the familiar 8 prong test of Rev. Rul. 59-60, 1959-1 C.B. 237.

4. Marketability Discounts are appropriate for minority interests because a ready market for shares does not exist.

5. The Courts have held that a premium will be paid for shares with voting privileges or conversely a discount is given for non-voting. The most widely known of the precedents in this area is the 1990 decision of the Tax Court in Estate of Newhouse (the publisher and major media mogul) which resulted in a per share difference of $350,000 for voting shares compared to non-voting shares. The Court of Appeals completely rejected the application of a premium (without reference to Estate of Newhouse) with regard to the Company, because control (which the estate lacked) could not be converted into any economic advantage.

Creation of two classes of shares has long been a basic element in succession and estate planning. A parallel device occurs in a family limited partnership with general partner interests and limited partnership units. Good planning has always dictated that the benefits of these devices is realized when minority status is attained for both the general partnership interest and the limited partnership units. Simplot adds a variation to the lesson first enunciated in Estate of Newhouse. If there are voting shares, reducing the interest of the decedent to a minority position is sufficient when there is no economic benefit derived by ownership of voting shares. This occurs when the number of voting shares is also a minority. A separate Voting Premium will increase the value of the voting shares only when the exercise of the voting rights can confer an economic benefit. When the number of voting shares are few compared to the total number of shares, if a Voting Premium is appropriate, even a very modest premium can have an extreme effect on valuation. Lastly, any increase in valuation can have horrific estate tax consequences to a desire to preserve voting control through the bloodline when the decedent makes an outright bequest of the balance of the estate to the surviving spouse.

Even though the IRS lost Simplot on appeal, it still has Newhouse. Therefore, the continued enunciation of a Voting Premium (if it converts into an economic premium) must be taken into account in all appropriate successor family and estate planning situations. 

Split Finger Fast Ball or a Hanging Curve Ball?

Title: Transfer on Death Ownership and Increases in the Ohio Estate Tax Credit

Publication Date: Dec, 2000

Author(s): Michael W. Rosenberg and W. Dallas Woodall

Since early 1999 the Ohio Legislature has been very active in the Probate/Estate Planning areas. A separate Article addressed the complete revision of the standards of fiduciary responsibility in moving from the prudent man to the Prudent Investor standard through the adoption of the Uniform Prudent Investor Act. Three other modifications of the Ohio law have been enacted within the same time frame with different effective dates and all of these present planning alternatives. When viewed in the aggregate it is difficult to ascertain whether all these changes represent planning alternatives which allow for a home run to be hit or create futile flailings at an impossible pitch that breaks into the dirt.

At the same time as the UPIA was adopted the legislature stuck a mighty spear into a rule which had been part of the common law from the days in England and continued in mostly unmodified form to current date. It was labeled the Statute Against Perpetuities. The purpose was to prevent non-charitable trusts from continuing for generations. The general rule in Ohio was that a private trust had to vest (terminate with distribution of its assets to its beneficiaries) during the period of time which was not longer than lives in being at the time of the creation of the trust plus 21 years. Accordingly, if a general estate planning trust was established and the settlor had then living children and grandchildren the longest time the trust could continue would have been age 21 of the great-grandchildren.

First South Dakota then Alaska and other states enacted wholesale revocations of their Statutes Against Perpetuities. The impetus is to create "dynasty trusts". A dynasty trust can take any one of several forms. However, the idea is to preserve wealth for future generations including those which were presently unborn. Since the situs of a trust can be the state where the trustee maintains an office and since CitiBank has offices in South Dakota and National City Bank has offices in Alaska, the impetus was to make Ohio as competitive as the sister states. As a result, Ohio's Statute Against Perpetuities was not revoked entirely but the old rule of lives in being plus 21 years is no longer applicable if the instrument creating the trust so provides. This has been standard drafting practice for the past year in our office in all new instruments and in all amendments of existing instruments.

The second Act by the Legislature is aimed toward the more modest estates. For years bank accounts could be "payable on death". An account would be owned by one person. However, upon the death of that person it would be paid to one or more designated persons. This is a device to avoid probate on the particular asset.

The concept has now been extended to real estate. Any real property in Ohio can now be re-deeded to provide for a "transfer on death". The similarity between POD and TOD is exact. A transfer on death designation is made by recording a deed. It lists the property in the name of the current owner and provides that upon the death of that person it passes to a designated person or persons. A TOD property is not subject to probate. Furthermore, no rights arise in the TOD recipient until death. At any time prior to death the POD designation can be terminated through the execution and recording of a new deed. In addition, if the TOD recipient does not outlive the property owner, the TOD designation becomes ineffective. No property rights arise in the heirs of a TOD recipient while the property owner is still alive. The combination of POD and TOD are appropriate alternatives to the creation of a general estate planning trust when the primary goal is to avoid probate.

The last Act of the legislature leads the authors of this Article to pose the baseball analogy. This Article has been written just after the hated Yankees added another dominating pitcher and it appears that our beloved Indians will lose Manny Ramirez and not have any viable alternative.

For many years the Ohio Estate Tax has been imposed on taxable estates in excess of $25,000. The actual phrasing of the tax is to give each estate a credit of $500. This exempted the taxable estates of $25,000. Ohio has had an unlimited marital deduction. However, for any estates in which there was planning for the federal estate tax through the creation of an Applicable Exclusion Amount Trust (or its predecessor The Credit Shelter Trust) a significant Ohio Estate Tax (approximately $32,000) would be imposed on the Applicable Exclusion Amount.

Beginning January 1, 2001, the credit allowed for the Ohio estate tax translates into an exemption that increases to $200,000. On January 1, 2002 it will increase to $338,000. Ohio has taken the same approach as Congress in eliminating the lower brackets when increasing the credit exemption. The range of rates will be between 5% and 7% as the brackets of 1%, 2%, 3% and 4% are consumed by the credit increase. What should be the form of planning for a married couple whose taxable estates would range between $200,000 and $676,000?

The concern is not the federal estate tax because the Applicable Exclusion Amount for 2001 is $675,000. Under current legislation this will continue to increase. The sole goal is to address the Ohio Estate Tax in planning for a married couple. The asset ownership could be completely POD and TOD. As a result there is both no probate and no tax paid upon the death of the first-to-die because of the unlimited marital deduction. However, now all the assets become owned by the survivor. If the total of the assets are greater than the Applicable Ohio Exclusion Amount then taxes paid upon the death of the second-to-die and an opportunity has been wasted to achieve double use by each of the married couple of the Applicable Ohio Exemption Amount. However, if ½ of the assets are less than the Applicable Ohio Exemption Amount then the most efficient Ohio Estate Tax planning occurs by not lumping the assets in the hands of the survivor. At least two methods appear to accomplish this goal. The first is the continuing use of a joint husband and wife trust with separate shares. The second which would be appropriate for real estate assets would be to have a TOD from the parent to the children but to reserve a life estate in favor of the surviving spouse. Both of these devices will prevent the bunching of assets and minimize the Ohio Estate Tax.

The techniques which have been used for federal estate tax planning for 7-figure and larger estates now appear to be equally applicable for planning of more modest estates to reduce or eliminate the Ohio Estate Tax. These opportunities are the direct result of the substantial increases in the Ohio exemption amount. In all instances planning can reduce Ohio Estate Tax by devices of asset splitting and preservation of a life interest for the benefit of the surviving spouse either through trust or by an instrument of conveyance. For married couples dying after December 31, 2000 which have total assets equal to two times the Applicable Ohio Exclusion Amount the Ohio Estate Tax savings would be $6,600. This increases to approximately $13,000 one year later. Therefore, some basic planning for a married couple will park the hanging curve on the home run porch at Jacobs Field. Failure to do so is the $6,600 or $13,000 strikeout.

 

  

Gifts to Minors

Title: The Greening of UTMA Funds

Publication Date: July 2000

Authors: Michael W. Rosenberg

THE GREENING OF UTMA FUNDS

A very common method of making a gift to a newborn or other minor is to purchase a security (shares of stock, a mutual fund, CD, etc.) in the name of the parent as custodian for the minor under the provisions of the Ohio Uniform Transfer to Minors Act, ("UTMA"). An UTMA gift is a cost free and almost brainless method to have a completed gift which removes the subject matter of the gift from the estate of the donor and provides that the property ultimately be owned free and clear of all restrictions by the designated minor. The alternative to an UTMA gift is the creation of a trust, either as a stand alone entity or a sub-trust under the general estate planning trust of the donor. The only real choices faced by the donor are the selection of the custodian and the specification of the duration of the custodianship. No donor names himself as custodian to avoid having the custodial property be considered part of the estate of the donor if the donor dies before the end of the custodianship. The duration can be from age 18 through age 21. The designation of the duration is made in the instrument creating the gift. Unless specified to the contrary under Ohio law, the duration of the custodianship will be until age 21.

Most custodianships begin with relatively modest amounts. It is anticipated that the funds will appreciate. A common goal of creating custodianships is to provide a fund that will assist in education. The requirement for termination at the attainment of a specific age and not later than age 21 can be both the blessing and curse of an UTMA arrangement. Upon the expiration of the custodianship the property which is then held by the custodian must be transferred to the beneficiary without restriction.

The two common instances which can cause a donor to reflect upon the wisdom of creating the custodianship were not anticipated at the time that the custodianship was initiated. The first of these is the real possibility that the beneficiary has no interest in education but a fond affection for motorcycles, fast cars, etc. The second concern is a product of the investment performance. What was anticipated to be $15,000 or $20,000 turns out to be hundreds of thousands if not a larger amount. This is not beyond a realm of possibility if the original gift in the late 1980's had been 100 shares of Microsoft, Intel, GE, etc.

When these two factors are combined a perfect situation has been created for an economic disaster. Even if the beneficiary does intend to pursue education that person may not be financially responsible to handle a huge UTMA distribution. There are two general approaches to deal with this situation.

In the first instance (I have prepared documents to this effect) it has been suggested to the child that notwithstanding the distribution of the UTMA assets to the child, the child would then create his or her own Trust. There can be a 3 year gap in time between attainment of the age of legal capacity and end of the UTMA. One of the lasting vestiges of the Vietnam War was the reduction from 21 to 18 as the age to execute binding legal documents. Therefore, at 18, a child can establish a trust and execute an irrevocable assignment to it which will become effective at a later date. The effective date of the Trust is one day after attainment of the age of distribution. The child also executes an assignment of the UTMA to the new trust. Mommy and Daddy are the Trustees. The duration of the Trust would be for a period of years. Discretion is given for distribution of principal and income. When this avenue is pursued the arrangement is always subject to later attack by child that he or she was coerced into agreeing to the creation of the Trust. A court could ultimately reach the same conclusion. Of course the old family lawyer has his own problems if he foolishly attempted to counsel both generations instead of requiring the child to hire his or her own lawyer. This technique is not effective for an UTMA that terminates at age 18.

Another approach has been suggested by an article that appeared in Fortune magazine. Everyone knows that a distribution of 10,000 shares of Microsoft to the 21 year old can be converted by the 21 year old into cash the next day. The same is not true if those 10,000 shares now become a certificate which represent a beneficial interest of 10,000 Units in the Rosenberg Family Limited Partnership. In the first instance typical with formation of limited partnerships that certificate would be subject to investment restrictions. Secondly and more importantly, there would be no market for that certificate. The persons who participate in the family limited partnership are the beneficiary, siblings, if any, Mommy and Daddy, Mommy and Daddy's trust, etc. The general partner would be a limited liability company which is controlled by Mommy and Daddy. The net effect of the swapping of the certificate for Microsoft for the certificate which reflects the ownership of limited partnership Units in Rosenberg Family LP is that Mommy and Daddy effectively control what were the UTMA funds and the inventory of the local Harley-Davidson, Mercedes Benz, etc. dealer would not be immediately reduced by one or more motor vehicles.

The authority for all this is contained in §1339.34 of the Revised Code of Ohio, as amended. The custodian has the authority to "hold, manage, invest, and reinvest the custodial property." In turn the custodian has authority to "sell, exchange, convert, or otherwise dispose of custodial property in the manner, at the time or times, for the price or prices, and upon the terms he considers advisable." A custodian has the specific authority to purchase securities. Securities are defined within the context of §1339.31(L) to include among specifically enumerated items to constitute "in general any interest or instrument commonly known as a security." There is no question under Securities Regulation that an interest in a limited partnership is a security and one which can be in registered form. Accordingly it would be the type of investment which is allowed to be required by an UTMA custodian.

There is a practical restraint which is imposed upon a custodian. Anyone who has established a trust authored by me received notice last year explaining the adoption by the Ohio Legislature of the Uniform Prudent Investor Act. This Act applies to all "Trustees". It substituted the Prudent Investor test as the proper criteria to determine whether or not the Trustee had discharged the investment duty with regard to trust funds. Notwithstanding the modification of investment criteria for trust funds the legislature did not modify the standard to measure investment by custodians. The pertinent language is contained in §1339.34(E) which reads as follows:

"The custodian, notwithstanding statutes restricting investments by fiduciaries, shall invest and reinvest the custodial property as would a prudent person of discretion and intelligence dealing with the property of another..."

Would a prudent man take custodial funds and invest them in a family partnership? Clearly the family partnership would have to be capitalized with more than the assets from the custodianship. Mommy and Daddy's Trust, the other siblings, etc. would also have to contribute. There are a number of good reasons why children invest with their parents. However, if the child does not agree it would appear that there could be an action by the child against the custodian for violation of the prudent man investment decision.

To a great extent the proper method to deal with these funds may lie in the area of parenting as opposed to available legal remedies. One theory about money is that teaching financial responsibility cannot be initiated at too young an age. However, if that has not occurred it appears that the continuation of the restricted access to UTMA funds is appropriate and if the child would not voluntarily create a trust a better method would be the creation of the family limited partnership. If this avenue is to be pursued it should be something which occurs years and not days before the magic birthday.

  

Family Limited Partnerships

Title: The IRS Fails to Make a Flip a Flop

Publication Date: January 2000

Authors: William N. Letson and Michael W. Rosenberg

THE IRS FAILS TO MAKE A FLIP A FLOP
Baine P. and Mildred C. Kerr v. Commissioner of Internal Revenue
113 T.C. No.30 (decided December 23, 1999)

A rage in family estate planning for a number of years has been the creation of a family limited partnership ("FLIP"). The goal is to transfer assets from parents to children and/or grandchildren on an accelerated basis by being able to use a discount from market value. Some readers of this letter will be thoroughly familiar with the technique since this office has either established family limited partnerships for them or discussed the subject at length. In Kerr, the Tax Court gave every client that has utilized this technique and every practitioner who recommends it a substantial victory which re-validates the entire process including discounts under current law after the novel approach taken by the IRS in attacking the entities created by Mr. and Mrs. Kerr.

Before analyzing the Kerr decision and the arguments made by the government and the taxpayers it is necessary to take a step back in time. What is a share of IBM worth? If it involves the direct ownership of that share, at any point in time reference can be made to the trades on the New York Stock Exchange. That medium represents the perfect market where knowledgeable buyers and sellers who each meet the classic definition of a willing buyer and willing seller establish that price. What is the value of one unit of a FLIP with 100 units outstanding that owns 100 shares of IBM? Anyone who is conversant with a FLIP, knows that the answer is not the value of that share of IBM. For years planners have advocated the establishment of family limited partnerships for the purpose of transferring wealth at an accelerated basis because the value of the one unit is subject to discounts (there are a number of valid business reasons to establish a FLIP, but none of those arose in the Kerr context). The common discounts that are always discussed are non-marketability, minority interest and lack of control. For planning purposes on a conservative basis, this office has always said that the combination of these factors are equal to 30%. The result of the discount through the utilization of the medium of a FLIP is that the economic effect of transferring 1½ shares of IBM can be accomplished at a tax cost of 1 share as a result of the discounts.

In Kerr the Internal Revenue Service either picked the right or wrong FLIP to attack utilizing the applicability of §2704(b) of the Internal Revenue Code of 1986, as amended. From one perspective, Kerr presented a prime target since the creation of the FLIP and transfer of Units was strictly motivated by the tax saving motives. None of the 26 business reasons listed in a treatise on FLIPs was present. The Kerrs were very wealthy and the opinion states that their children were all independently wealthy. The IRS did roll out a new piece of heavy artillery to serve as its prime weapon for attempting to prevent discounting of interest in FLIPs. To continue the military analogy, the IRS launched what it felt would be an ICBM with 100 nuclear warheads and discovered that its missile was a July 4th sparkler that never ignited.

For anyone who read Oil and Honor, the thoroughly enthralling account of the Texaco-Pennzoil wars for Getty Oil written by Thomas Petzinger, Jr. (of Youngstown), the name of Baine Kerr should strike a bell. Mr. Kerr had been President of Pennzoil during that period of time and the Tax Court decision notes that he received a $10 million bonus at the conclusion of that take over. Although Mr. Kerr was a lawyer, he hired S. Stacey Eastland, an attorney at Baker & Botts in Houston (his old firm) to do his estate planning for him. Attorney Eastland is one of the writers of the "book" on using FLIPS. Two articles written by Attorney Eastland were cited by the Tax Court in its opinion including one published after the present case had moved into the litigation area.

Two different FLIPS were created. One became the owner of insurance policies. This FLIP in turn became a partner in a second FLIP which owned cash, securities and other investment assets. Each agreement was created under the Texas Uniform Limited Partnership Act. Each provided for the standard provisions preventing free transferability of units and bifurcated rights between any transferee and the transferor until the General Partner consented to the transfer. The provisions relating to restrictions upon transfer provided the battle ground for the IRS to launch its assault. These are standard provisions in both a FLIP and any limited partnership. In addition, probably every other bell and whistle that can be imagined was added by Attorney Eastland to the entire scheme. This included making a transfer of interest to persons who would only be assignees and later would be admitted as limited partners, creating different classes of limited partnership units and adding the University of Texas as an assignee and ultimately a limited partner. Obviously if Attorney Eastland writes about these techniques, he will use them in practice. There is an installment sale of interests by the Kerrs to a Grantor Retained Annuity Trust established by them (the tax effect of that aspect of the transaction is a separate estate planning technique, was not part of the case before the Tax Court, and is not relevant to this discussion).

Adding the University of Texas to the mold and separating rights of an assignee versus outright ownership of a limited partnership unit were the embodiments of theories which had been developed by Attorney Eastland specifically to combat the argument made by the Internal Revenue Service in the instant case. Kerr was decided without the court considering the efficacy of these nuances.

A FLIP is the response of estate planners to a device that was extremely popular prior to Congress coming to the aid of the Internal Revenue Service by outlawing a number of techniques which would cap growth. The usual situation involved a family business. Parents often were willing to give up future growth in a family business while retaining control. The most common form of this went under the name of an estate freeze by creating a class of preferred shares which had voting rights and issuing all of that to the parents. This would use up all the value of the company. In turn, the existing common would become non-voting. Because preferred has a stated liquidation value, all future growth would be attributed only to the common shares. The common shares would be given to the children. Therefore, all appreciation in value would pass free of transfer taxes. The truly sophisticated plan had two classes of preferred with only one of them having voting rights. The parents would then undertake a giving program to transfer the preferred to the children reserving until the end voting rights which would be the subject of either the last gift or the bequest.

The final legislative response to this scheme is the enactment of §2701 through §2704. The basic thrust is to give no value to any gift when there is any one of a number of retained interests. In this instance the IRS argued that the specified retained interest would be the ability in the family context after making a gift of an interest that was subject to restrictions because of the continuing control of the entity by the family. As a result, the family had the ability to remove the restrictions. Section 2704(b) specifically addresses this situation with an important exception. These are the same sections which now limit grantor retained income trusts to personal residences and have kicked most of the teeth out of buy-sell agreements among family members. For years, the IRS had without end lost cases attacking discounts on other theories. Thus, advocating §2704 represented a new approach and the Kerr situation could have been a very easy target if the Tax Court would have been amenable to this legal argument. The Internal Revenue Service argued that §2704(b) is applicable to a family limited partnership and therefore valuation discounts are inapplicable for the types of gifts made by Mr. and Mrs. Kerr because of the alleged retained interest to remove the restrictions against transferability.

The taxpayers had loaded up their quiver with a lot of arrows including the two devices which had been the subject matter of the articles of Attorney Eastland. The Tax Court did not have to determine whether or not adding a charity which is an owner over which the transferors have no control or splitting the ownership of an interest between an assignee or a transferor are necessary to defeat §2704. The decision of the Tax Court is based solely on the provisions of the Texas Uniform Limited Partnership Act. Parallel provisions are included in the Ohio Revised Uniform Limited Partnership Act. Section 2704(b) does contain an exception arising from prior law concerning restrictions which are imposed by state law. The decision in Kerr is based solely on the general statutory scheme for a limited partnership and the Treasury Regulation which was promulgated under this section. The relevant portion of the opinion reads as follows:

"Section 25.2704-2(b), Gift Tax Regs., provides that an applicable restriction is a restriction on "the ability to liquidate the entity (in whole or in part) that is more restrictive than the limitations that would apply under the State law generally applicable to the entity in the absence of the restriction."

In sum, section 2704(b) generally provides that, where a transferor and his family control a corporation or partnership, a restriction on the right to liquidate the corporation or partnership shall be disregarded in determining the value of an interest that has been transferred from the transferor to a family member if, after the transfer, the restriction on liquidation either lapses or can be removed by the family."

In finding for the taxpayers, the Tax Court concluded that the Internal Revenue Service had been hoisted by its own petard since the cited provision of the regulation is more liberal than the statute. The conclusion provides judicial approval at the Tax Court level for the technique of creating a family limited partnership and achieving discounts by transferring minority interests. The minority interests themselves are not transferable freely because of restrictions which are contained in the partnership agreement. These restrictions themselves are an outgrowth of the limited partnership law.

Certainly this is not the last word on this subject. The legislation proposed by President Clinton in 1999 specifically addressed this issue. The Administration's proposal would have reached the type of activity which occurred in Kerr. The administrations proposal would only allow valuation discounts for actual businesses as opposed to the portfolio of investment assets. Since the first news stories of the domestic policy agenda for 2000 include a resubmission by the administration of a tax cut bill, this subject may again be on the front burner. The IRS may appeal Kerr or not acquiesce on the decision. Anyone who is considering the adoption of a FLIP for solely wealth transfer purposes only is well advised that sooner is most definitely better than later because later may not exist.

  

Uniform Prudent Investor Act

Title: Investment by Trustees

Publication Date: June 1999

Authors: W. Dallas Woodall and Michael W. Rosenberg

INVESTMENT BY TRUSTEES

Effective March 22, 1999, the Ohio Legislature has adopted the Ohio Uniform Prudent Investor Act as set forth in §1339.52 through §1339.61 of the Revised Code of Ohio, as amended. The Act now applies to all trustees. For the first time it specifically imposes investment duties and responsibilities under persons who act as trustees under an instrument created during the lifetime of the Settlor. At the same time the provisions are equally applicable to trusts created by will and do not become operative until the death of the Settlor. The applicable criteria for the investment performance by a trustee is now the Prudent Investor Rule. This is contrasted with the Prudent Man Rule. In Ohio, for living trusts, the Prudent Man Rule was the only governing provision. The Prudent Man Rule was formulated in the 19th century when preservation of capital was the primary goal of any trustee. As a result, risk would be avoided and production of an assured stream of income was paramount. Consistent with this approach, trust accounting has always made a bright line distinction between the income which is received upon the sale of a capital asset as opposed to the income derived from the ownership of that same asset. By way of example, if a trust owned 100 shares of General Electric the annual dividend would be income. When the trust sold the 100 shares of General Electric and realized a gain measured by the difference in the sale price of the shares over the investment in the shares all of that gain would be allocated to principal. None of it could be distributed to a current income beneficiary.

The several provisions of the Uniform Prudent Investor Act result in moving from the 19th century concept to a contemporary realization that risk is relative to return and a trustee must take total return in consideration when investing an entire portfolio as opposed to determining the income which is generated from each asset which comprises the portfolio.

The Ohio Uniform Prudent Investor Act is based upon Uniform Prudent Investor Act adopted by the National Conference of Commissioners on Uniform State Laws which was adopted by the Commissioners in 1994. In adopting the Act the Commissioners established five fundamental criteria for prudent investing as follows:

1. Prudence is applied to the entire portfolio not individual investments.

2. The central consideration of the fiduciary is a trade off between risk and return.

3. There will be no restrictions on the types of investments. The trustee can invest in any asset so long as the risk/return objectives of the trust are met.

4. Prudent investing includes diversification.

5. Delegation of investment and managerial functions is now permitted and even encouraged.

In addition to these general objectives, all of which are incorporated into the provisions of the Ohio Act, the following features now appear:

1. The trust instrument can expand, restrict, eliminate or otherwise alter any of the provisions of the Act. When there has been any such action by the Settlor, the trustee is not liable to any beneficiary to the extent that the trustee acted in a reasonable reliance on the provisions of the trust.

2. The Act clearly recognizes that there are both professional and amateur trustees. Each of them are held to a different standard so that the standard for a professional money manager to provide investment performance is higher than that which would be applied to a family member.

3. The essence of the Act is set forth in §1339.53(D) which reads as follows:

"A trustee's investment and management decisions respecting individual trust assets shall not be evaluated in isolation but within the context of the trust portfolio as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to the trust".

The Act then lists eight different circumstances that a trustee should consider in investing and managing trust assets, to the extent that any of them is relevant to either the trust or its beneficiaries.

(1) the general economic conditions;

(2) the possible effect of inflation or deflation;

(3) the expected tax consequences of investment decisions or strategies;

(4) the role that each investment or course of action plays within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property;

(5) the expected total return from income and appreciation of capital;

(6) other resources of the beneficiaries;

(7) needs for liquidity, regularity of income, and preservation or appreciation of capital;

(8) an asset's special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.

4. A trustee is required to diversify. If a trustee does not diversify, it must be after a reasonable determination has been made that because of special circumstances the purposes of the trust are better served by not diversifying. As a general rule, the easiest way to achieve diversification is through investment in a mutual fund. There are many situations in which diversification cannot be achieved. The delineation of trust powers clearly addresses this situation. It can arise in any number of circumstances, including ownership of interest in a family business, ownership of interests which are not publicly traded and ownership of real estate assets.

5. The duty of active management has two aspects to it. First of all the trustee is required to minimize investment costs. Secondly, within a reasonable time after receiving assets or beginning to serve, a trustee has to review the assets, make and implement decisions concerning retention and disposition in order to bring the portfolio into compliance with the purposes, terms, distribution requirements and other circumstances of the trust in order to be in compliance with the Act.

6. The delegation of management and investment functions in a separate undertaking. When it is done with reasonable care, skill and caution, the delegation exonerates the trustee from liability to the beneficiary for the acts done by the agent. The trustee selects an agent, establishes scope and terms of authority and periodically reviews the performance of the agent.

There are a number of consequences to the Act. In the first instance the trustee is now under a specific investment microscope. This will be applied as of the time that a decision was made and not after the fact. However, the trustee now has liability for investment performance by comparing the total return of the portfolio compared with what the portfolio could reasonably expect to return under an appropriate investment program. Since risk tolerance is now a concept of investing, greater portions of portfolios will consist of equity as opposed to income securities.

Accept for the situations in which "income" must be paid as mandated by law (i.e., a Marital Deduction Trust), distributions made on an annual basis could be structured with a base of the total return as opposed to the traditional income/principal differentiation. This technique already occurs in split interest trusts whether for the benefits of charities or established under §2702 of the Internal Revenue Code. The clearest example of this is a charitable remainder unitrust in which there is a distribution on an annual basis which is measured at a set percentage of the fair market value of the assets as of the first day of the year. As a result, the distribution will increase as asset size increases and correspondingly decrease when there is a reduction in asset size. Income could be defined as return from a principal asset together with a portion of the receipts from sale or exchange from liquidation of a principal asset.

The Uniform Prudent Investor Act was not adopted in a vacuum. In 1987 the General Assembly enacted the Uniform Principal and Income Act. At the risk of oversimplification there are two basic thrusts of the Principal and Income Act. The first is to differentiate between items of receipt and expense which are to be considered or charged against income and principal, respectively. The second is to define unproductive property and establish a required pay out from the proceeds from the sale of unproductive property once said has been sold.

The majority of situations which concern any estate planning client are bound one way or another to the allowance of the marital deduction. The marital deduction arises when the estate of the first spouse to die has assets in it in excess of the then Applicable Exclusion Amount. When this excess is not distributed directly to the surviving spouse it is held in trust for the benefit of the surviving spouse during the life of the surviving spouse. Whether the form of trust is a power of appointment trust or qualified terminable interest property, the statutory requirement is that "all of the income" must be paid to or for the benefit of the surviving spouse for the life of the surviving spouse. Treasury Regulation §20.2056(b)-(5)(f) is very broadly written and has been interpreted by both judicial decisions and technical advice memorandum issued by the Internal Revenue Service to preserve the benefit of the marital deduction when there is an evident intent of the decedent to create a marital deduction trust and provide the required income interest for the benefit of the surviving spouse. The appropriate provisions are as follows:

"...If the effect of the trust is to give her substantially that degree of beneficial enjoyment of the trust property during her life which the principles of the law of trusts accord to a person who is unqualifiedly designated as the life beneficiary of the trust (the statutory requirement will be met). Such degree of enjoyment is given only if it was the decedent's intention, as manifest by the terms of the trust instrument and the surrounding circumstances, that the trust should produce for the surviving spouse during her life such an income, or that the spouse should have such use of the trust property as is consistent with the value of the trust corpus and with its preservation. The designation of the spouse as sole income beneficiary for life...will be sufficient to qualify the trust unless the terms of the trust and the surrounding circumstances considered as a whole evidence an intention to deprive the spouse of the requisite degree of enjoyment. In determining whether a trust evidences that intention, the treatment required or permitted with respect to individual items must be considered in relation to the entire system provided for the administration of the trust....

If it is evident from the nature of the trust assets in the rules provided for management of the trust that the allocation income of such receipts as rents, ordinary cash dividends, and interest would give to the spouse a substantial enjoyment during life required by the statute, providing that such receipts of stock dividends and proceeds from the conversion of trust assets shall be treated as corpus will not disqualify the interest passing in trust. Similarly, provision for depletion charged against income in the case of trust assets which are subject to depletion will not disqualify the interest passing in trust, unless the effect is to deprive the spouse of the requisite beneficial enjoyment. The same principle is applicable in the case of depreciation, trustees' commissions, and other charges."

There is an interplay between the Treasury Regulation, the Uniform Principal and Income Act and the Uniform Prudent Investor Act when assets will be held for the benefit of the surviving spouse and a trust that will qualify for marital deduction purposes. The illustration is of the most obvious example. The Uniform Prudent Investor Act demands diversification. Unless the size of the assets are sufficient to allow diversification into equities, the most obvious solution is to buy mutual funds. By way of example, the trust department of a local financial institution does not believe that it has a sufficiently diverse portfolio if, at the time of the creation of the portfolio, any single equity represents 5% or more of the value of the total portfolio. If this translates into a purchase of twenty-five (25) equities and the average share price is $50.00 per share and upon a further assumption that the investment should be at least $20,000.00 per issuer, diversification results in a portfolio size of $500,000.00. The easy alternative to achieving diversification with the same number of dollars is to purchase five (5) different mutual funds and invest $100,000.00 in each of the funds. The selection of the funds would be made in such a manner as to cover broad market areas that a professional money manager would deem to be appropriate in the circumstances.

Except for a money market fund every mutual fund generates two types of income. The first would be dividends. The second are capital gains distributions. Capital gains distributions arise when the mutual fund itself sells shares which it has owned in issuers. Under the Uniform Principal and Income Act all distributions made by a regulated investment company (mutual fund) which are not ordinary income in whatever form made are treated as principal.

The application of the Uniform Prudent Investor Act to the Uniform Principal and Income Act within the context of the marital deduction trust can result in the worst of all possible situations. I believe that I can state unequivocally that for every marital deduction trust that I have created during the discussions with the couple, both spouses have always said that their primary intention is to provide the maximum amount of income for the benefit of the surviving spouse during the life of the surviving spouse. Unless there is some modification of income within the context of the marital deduction trust, one obvious conclusion that can be drawn is that the avowed intention of the adoption of the Uniform Prudent Investor Act to give income beneficiaries the benefit of stock market appreciation would work to the contrary. Principal has always included receipts from the disposition of corporate securities.

Is there a way out of this dilemma? The goal has always been to reduce the value of the marital deduction trust during the life of the surviving spouse. It will be taxed at a very high rate. If the trust is a power of appointment trust, then the limited power of appointment can be given the spouse in each year to reduce the principal by means of gifts to the children and grandchildren. However, that may not be practical to deal with galloping share appreciation. Clearly, income must be redefined.

There are two approaches to this. In the first instance income can mean what it normally it means, which is dividends, rents, interest, etc. It can also be expanded to include all or a portion of realized capital gains. The concept of taking this approach is to recognize that the value of the marital deduction trust may grow, at least to the extent that when gains are realized some or all of them can be distributed to the surviving spouse.

The second approach is to borrow a concept from split interest trusts. When either a charitable remainder or a charitable lead trust is created there is income or remainder interest which will flow to the benefit of individuals. A split interest charitable trust receives its beneficial treatment if the amount of the annual distribution is either an annuity or a unitrust amount. An annuity is the percentage of the value of the trust at the time of its creation. A unitrust payment is a percentage of the value of the trust as of the last day of the preceding calendar year. When inflation and/or share appreciation is a reasonable anticipation, the unitrust method is usually adopted because it results in a greater distribution of income on an ongoing basis and it is anticipated to increase in all subsequent years.

This second solution adopts the requirement for a unitrust payment. This would be expressed as either the greater of the income or the unitrust amount. The effect is to share with the surviving spouse the benefit of the realized appreciation in assets. In order to make a unitrust payment it would more likely than not require liquidation of assets. There is nothing wrong in converting some shares of Microsoft to cash in order to enhance the income distribution to the surviving spouse.

A variation of both approaches could provide that the income is all that is generated, plus a percentage of both realized and unrealized appreciation which would be in excess of a bench mark.

The creator of a trust now has many additional concerns in giving directions to the trustee for the distribution of income. Diversification and equity investment is now mandated for all trustees, whether they be family members or professional trustees. The Settlor must be cognizant of these requirements in connection with the drafting of trust instruments. Income could be defined differently of an Applicable Exclusion Amount Trust as compared with a Marital Deduction Trust.

  

Pre-Nuptial Agreements

Title: The NBA Strike, Marital Property and Succession Planning

Publication Date: December 1998

Authors: Thomas B.J. Letson and Michael W. Rosenberg

THE NBA STRIKE, MARITAL PROPERTY AND SUCCESSION PLANNING

This memorandum is being prepared when there is strong indication that there will not be a 1998-1999 National Basketball Association season. Thus, this introductory paragraph in subsequent years may become as topical and unintelligible to subsequent generations as the jestings of the day following the murders in Macbeth are to us. However, legal research is where you find it and not always in statutes and decisions of appellate courts. Jayson Williams, who otherwise is a very articulate and highly skilled basketball player, is a free agent who has negotiated the terms of the very lucrative multi-year contract with his employer of last year, the New Jersey Nets. Unfortunately, Mr. Williams cannot sign this agreement. In an article in Sports Illustrated he complained that he could not complete arrangements with marriage with his intended because the "prenup" cannot be completed until the final details of his next contract have been reduced to writing. Although subsequent letters to the editor have roundly roasted Mr. Williams and his professional colleagues for comments which all of them made about cinching their belts tighter because of the continuing NBA strike, his comment concerning the use of prenuptial agreements ties in very neatly with the decision rendered by the Supreme Court of Ohio in Middendorf v Middendorf 83 Ohio State 3d (1998).

A little background is illuminating. Years ago the use of prenuptial agreements was almost always restricted to situations of second marriage when either or both of the spouses had children from a prior marriage. The basic thrust of the historic use of the prenuptial agreement was to provide that the second (third, fourth or fifth, etc.) spouse would not be able to assert rights as a surviving spouse under the laws of descent and distribution. Although the percentage of an estate which could be claimed by a surviving spouse has changed by statute together with addition of other rights which are accorded to a surviving spouse the general provisions of historical prenuptial agreements would provide that the children of each spouse would inherit whatever each spouse brought into the marriage. Marital property normally would be limited to new property that was acquired during the period of marriage. Growth of the old property normally would also be excepted from consideration as marital property.

As Mr. Williams states, prenuptial agreements are now more widely used for first marriages. This is a phenomenon of either substantial wealth or earning power which either of the prospective couple possess. The Middendorf decision is the first review by the Supreme Court of Ohio of modification of §3105.171 which became effective on January 1, 1991, the Supreme Court in Middendorf was faced with applying a new definition of "marital" and "separate" property. The text of the specific sections which were considered by the Court include the following:

- §3105.171(A)(3)(a) means ... "(iii)... all income and appreciation on separate property, due to labor, monetary, or in kind contribution of either or both of the spouses that occurred during the marriage".

- §3105.171(A)(6)(a) states "separate property" means all real and personal property and any interest in real or personal property that is found by the Court to be any of the following: ... (iii) passive income and appreciation acquired from separate property by one spouse during the marriage".

- §3105.171(A)(4) states "passive income" means income acquired other than as a result of the labor, monetary or in kind contribution of either spouse."

Middendorf constituted a second marriage for the husband. The record is unclear as to whether or not the wife had been previously married. Mr. Middendorf had three children from a prior marriage. The duration of the Middendorf marriage was slightly greater than 5 years. At the time of the marriage, the husband was a livestock buyer for a business in which he and his brother co-owned. The wife had been self-employed prior to the marriage but during the period of the marriage ceased to be employed.

The issue presented was whether or not an increase in value in the shares of the family business owned by the husband during the period of marriage constitutes marital property. There is no question in Ohio that prior to the modifications to §3105.171 cited above that the shares of the family business owned by the husband prior to his marriage would have been separate property unless he had commingled those shares. The normal form of commingling would have been to retitle the shares in the name of the husband and wife under some form of joint ownership or outright transfer to the wife. However, continued ownership in the same form as existed prior to marriage under the old law would have preserved the qualification of the shares as separate property and neither the shares nor any increase in value would have been subject to the jurisdiction of a domestic relations court.

Based on the statute and the facts of Middendorf, it was very easy for the Supreme Court to conclude that the increase in value was marital property and would be taken into account in determining the property of the Middendorfs that would be subject to division by the Court. The husband worked for the family business. He was the principal buyer and was involved in management on a continuing basis. Both the trial court and the appellate court characterized his participation as a "direct result of the pivotal role played in management" and a "vital role in management". Thus, based upon the record and the clear language of the statute, the Supreme Court had to conclude that the shares of the family business were marital property and the increase in value were within the jurisdiction of the domestic relations court in determining a division of marital property.

Mr. Middendorf was a whip-saw victim. He married before the change in law became effective. Unlike numerous citations of "grandfathering" which arise in federal income situations under the Internal Revenue Code, §3105.171 applies no matter when the property was acquired nor when the marriage commenced. Its provisions are applicable for marriages which terminate after the effective date. Accordingly any person who was married under the old law could face the same situation as Mr. Middendorf. Nothing can be done to save the pre-marital property when any one of the six prongs discussed below occur.

Consider all of the following:

1. The shares in the family business are owned by the husband but the wife is the one who works in an executive capacity over vice-versa, i.e., finding a spot for the son-in-law. Middendorf holds that marital property includes property where the increase in value is a result of the labor, monetary, or in kind contribution of either of the spouses. Thus, there are six different variables in any situation of property owned prior to a marriage. The first is the determination of ownership and that is either the husband or wife. The next determination is whether or not the increase in value is due to the labor, monetary or in kind contribution of either of them. Mr. Middendorf tried to argue that the increase in value was a result of a stock market axiom that a rising tide lifts all boats and was not a result of his management services. While all the courts rejected that argument in Middendorf it could be plausibly made by a person who is not employed in a management capacity and has not made monetary or in kind contributions. What is a monetary contribution? This matter was not before the court in Middendorf. In the strictest sense, leaving capital in any business is a monetary contribution on the theory that all equity either reduces borrowing, allows continued business operations without contraction or permits expansion. Other forms of monetary contribution could be a new loan, extension of term of old loan, additional shares, etc. Thus while Middendorf addressed the labor prong in one facet, the contributions other than services have not yet been addressed by the Supreme Court.

2. There could be situations in which both the husband and wife own shares in the business prior to marriage. An example would be a company in which ownership has been extended to key employees. Either one of the two could have been a key employee and acquired shares under an option plan. More than one second marriage has grown from the garden of employment. If this marriage then goes on the rocks and if either one of the spouses meets the three-pronged test, all of the shares are marital property and all of the increase in value is marital property to be divided.

3. Family business can become transformed. A common example is a successful family business which is acquired by another company. If the medium of exchange is securities of the new company, I suggest that Middendorf can be read to bifurcate the increase in value. Consider this example, either one of the spouses is active in the family business and the shares have a value at the time of marriage of $100,000. The shares increase to $200,000 when the company is acquired by a company whose shares are traded on an exchange. Over the next several years and while the marriage abides, the shares increase in value to $1,000,000. If one of the parties to the marriage did not work for the acquirer, the two sections of 3105.171 cited above provide a very pervasive argument that the marital property aspect of the shares would be limited to the increase in value during the period of time in which the one spouse was involved in management. The further spike in value should follow within the definition of appreciation from separate property other than a result of labor, monetary or in kind contribution. Is the result the same if the spouse has a mid-management level or lower position with the acquirer?

This becomes of great moment when there is any form of family business. Either one of the prospective spouses may or may not own shares at the present time. However, it is certainly contemplated that if there will be any succession in a family business, shares will be either given to or inherited by a younger generation. In structuring business succession and estate plans, in more than 30 years no client has ever said to me, "I want the in-law to end up with the family business". The opposite is the desired method which provides for the passing of the interest to the son or daughter and thereafter limiting the persons that can acquire the interest to someone who is a child of the son or daughter and issue of the parent which will insure that the interest will always follow the bloodline.

We interpret Middendorf and §3105.171 to be an absolute requirement that any child who either owns or anticipates will own any property which has any potential for appreciation in value as a result of the efforts of that person or spouse or increase in value through a monetary or in kind contribution to enter into a prenuptial agreement. The prenuptial agreement with respect to this property can take any form. It can follow the traditional path that the designated property is separate property for all events. There can be cutbacks from the absolute black and white. A portion of the increase in value could be determined to be marital property. If this approach is taken the parties should agree how the increase in value is determined. Middendorf became a battle of the valuation experts with the Supreme Court ultimately accepting the decision reached by the trial court on remand after hearing testimony from experts on both sides. The parties could agree to a formula and the application of the formula eliminates the necessity for utilization of expensive experts which only adds to the total cost and frustration of the wind up of the marriage.

In many respects parenting is a lifelong job. Certainly when an intended appears on the horizon this is a subject which should be discussed at length with the particular son or daughter. The more valuable the share in the family business, the more disastrous a dividing of a non-liquid asset could become in the event of a termination of marriage. There is one very practical alternative for gifts and/or testamentary transfers to a married child when a pre-nuptial agreement does not exist. The medium of transfer is to a trustee under a written trust created by a parent is not marital property of the child.

  

"REDUCTION IN THE FEDERAL COST OF DYING"

Title: Estate and Gift Tax Aspects of the Economic Growth and Reconciliation Act of 2001

Publication Date: May, 2001

Author(s): Michael W. Rosenberg

The fifth major division of the Economic Growth Tax Relief Reconciliation of 2001, (the "Act") addresses provisions relating to estate, gift, and generation-skipping transfer tax matters. Within this division there are five separate topics. Four of these are highly technical, of limited applicability and will not be addressed in the context of this article. Notwithstanding any other provisions of the Act which may not have been part of the proposal originally submitted to Congress by President Bush, he can claim a ringing victory in the final outcome of changes in the estate and gift area. One aspect of the original proposal, rapid reduction in rates did not occur in the Act. Whether or not the fundamental concept, ultimate repeal, abides until the year 2010 will be determined by legislation proposed by subsequent administrations and addressed by Congress between now and then.

The estate planning aspects of the legislation include the following:

1. The Applicable Exclusion Amount which is currently $675,000 for each individual and does not increase until $1,000,000 until 2006 is increased to $1,000,000 on January 1, 2002. There are subsequent increases in the Applicable Exclusion Amount to $1,500,000 on January 1, 2004, $2,000,000 on January 1, 2006, and $3,500,000 on January 1, 2009 with the ultimate repeal of the estate and generation-skipping transfer tax for decedents dying after December 31, 2009.

2. There is a shrinking of the highest rates imposed beginning in 2002 on the estate and gift tax rates to 50% in 2002, 49% in 2001, 48% in 2004, 47% in 2005, 46% in 2006 and 45% in 2007.

3. For estates which do pay the federal estate tax, there is a modification of the state death tax credit in the years 2002 through 2004 by 25% per year. Beginning in 2005, the state death tax credit is repealed. At that time there will be a deduction for death taxes actually paid to a state.

4. Under current law any asset which is part of the taxable estate as of the death of the decedent has a new basis in the hands of the recipients. This is the fair market value of the asset either as of the date of death or on the valuation date which is generally 6 months after the date of death. Effective in 2010 this step-up in basis will be replaced by a modified carry over basis regime. Generally all recipients of property transferred at the death of a decedent will receive a basis equal to the lesser of the adjusted basis of the decedent or the fair market value of the property on the date of death.

5. In very technical terms for many years there has not been a separate differentiation between the taxes imposed for gifts made during lifetime and transfers taking effect at death. Common parlance often referred to gift taxes and estate taxes separately. In the terms of the statute there were not separate taxes but rather separate components of a unified rate tax. Under the Act, the concept of uniformity terminates in two ways. In the first instance, the Applicable Exclusion Amount effective exemption for gift tax purposes will remain at $1,000,000 even though the exemption amount for estate tax purposes increases. Secondly, with the repeal of the estate tax effective for decedents dying after December 31, 2009, the fissure of estate and gift taxes is complete. A gift tax will remain. The gift tax rate will be the top individual rate then in effect. Under another provision of the Act, this is 35%.

Although every estate planning situation is different, several general conclusions can be drawn.

1. Because of the resurrection of a carry over basis even in a modified regime (which was a flaming disaster enacted in the Tax Reform Act of 1986 and subsequently repealed back to its date of original enactment) the actual cost basis for assets will be an essential factor in determining value at the date of death since a property recipient will have as a basis the lesser of the decedent's cause or the date of death value.

2. For any person who is committed to a giving program in excess of the per donee annual exclusion (currently $10,000 or $20,000 for a married couple giving to the same individual) the optimum time for making of the gifts is January 1, 2002. There will be no increase in the exemption amount applicable to gifts. As a result, if the subject matter of the gift is property which should appreciate in value the best time to give it is the first day in which the increase in the exemption amount occurs or January 1, 2002. Delay in giving results in the potential for value appreciation. In addition, since a gift made in excess of the per donee annual exclusion made within three years of the date of death is brought back into the estate at the date of death value, delay only increases the potential for estate inclusion.

3. Many married couples have looked at funding of the estate tax bill through the purchase of various forms of policies of life insurance including a second-to-die policy through the medium of an irrevocable trust. If the changes incorporated by the Act are not modified by Congress in later years, the need for a pot of money to pay estate taxes will no longer exist. There would be a great incentive to cash in policies and terminate any trust owning a policy. This would be to the substantial economic detriment of life insurance companies. There will be many instances of excess coverage now, even for deaths occurring prior to 2010. An examination of death tax costs will be appropriate for every person who has established an insurance program solely for wealth replacement purposes. A variation on this theme includes charitable split interest arrangements based on the same concepts.

4. One of the attractions of residency in Florida has been its lack of a state estate tax. Florida did derive considerable revenue by use of the state death tax credit. With the demise of the state death tax credit, Florida and a number of other states which had a "sponge tax" to soak up the federal state death tax credit will probably now legislate a state death tax in order to recapture the amount received by reason of the application of the credit. There will be no ultimate cost to any decedent (absent any rate changes) since the credit will be a direct deduction in the determination of the federal tax.  

Gifts to Minors

Title: Should There Be A Re-examination Of Wealth Replacement Insurance and/or Annual Funding of Irrevocable Trusts?

Publication Date: July 2001

Authors: Michael W. Rosenberg

SHOULD THERE BE A RE-EXAMINATION OF 
WEALTH RELACEMENT INSURANCE AND/OR 
ANNUAL FUNDING OF IRREVOCABLE TRUSTS?

When it becomes fully effective, the Economic Growth and Tax Relief Reconciliation Act of 2001, (the "Act") provides for the outright repeal of the federal estate tax and federal generation-skipping transfer tax for decedents dying after December 31, 2009. As the law currently exists, this repeal would be effective for the year 2010. Congress must adopt subsequent legislation which either extends the years covered by the Act or makes provisions of the Act permanent. No one has a crystal ball. If nothing occurs beginning January 1, 2011, gift estate and generation-skipping transfer tax matters after December 31, 2010 will be governed by the law in effect on January 1, 2001.

The total repeal of the gift estate and generation-skipping transfer tax affects only the very wealthy. The difference between January 1, 2002 and the Applicable Exclusion Amount for federal estate and generation-skipping transfer tax purposes affect every other person that would have had a taxable estate but for the provisions of the Act. The increases in the Applicable Exclusion Amount for estate and generation-skipping transfer tax are immediate and become significant as follows:

Year Applicable Exclusion Amount

2002, 2003 $ 1,000,000

2004, 2005 $ 1,500,000

2006, 2007, 2008 $ 2,000,000

2009 $ 3,500,000

A traditional method of providing liquidity to an estate to pay estate taxes has always been the purchase of life insurance. With the advent of the unlimited marital deduction the payment of estate taxes for both federal and state purposes (for those states which follow the federal system) would only arise upon the death of both spouses. Thus, the insurance industry developed the second-to-die policy which would insure two lives for a lower premium than insuring each life separately. One of the terms of marketing for a second-to-die policy was the label of "wealth replacement". A variation was insuring the younger and/or healthier (read non-smoker) of the couple.

The policy of wealth replacement would be either owned by the next generation or an irrevocable trust for the benefit of the next generation. Neither of the insureds could have any incidents of ownership in the wealth replacement policy. Control of the incidents of ownership would only add the proceeds back into the taxable estate and create a pyramiding effect.

One possible approach that Congress could take if total repeal becomes fiscally irresponsible is to lower rates and maintain the higher Applicable Exclusion Amounts when were included in the Act, i.e., a 25% rate and an Applicable Exclusion Amount of $2,500,000, $3,000,000 or $3,500,000. In this scenario federal estate taxes for a married couple with proper asset splitting and planning only become a concern when the total assets for the couple exceed 5, 6 or 7 million dollars. However, in the last decade many couples with gross estates in excess of $1,500,000 but below the newly legislated Applicable Exclusion Amounts have purchased various forms of wealth replacement insurance.

Normally the insureds were the source of funding to pay annual premium. When a trust was used as the owner and beneficiary of the wealth replacement policy there would be an annual contribution made by the insureds to the principal of the trust in excess of the premium. Normally any gift which is made to a trust is considered to be a "future" interest and is not eligible for the per donee annual exclusion of $10,000. If this were the case the payments of premiums would be taxable gifts and reduce the Applicable Exclusion Amount which otherwise would be available at the time of death.

Ever since 1976 and a decision of the Sixth Circuit Court of Appeals, a gift in trust has been deemed to be a present interest and eligible for the per-donee annual exclusion if the beneficiaries of the trust had the right to withdraw the amounts which had been contributed during the year. The Internal Revenue Service ever since it lost the Crummey case, has fought an uphill battle against the expansion of this doctrine. The Crummey doctrine was widely expanded by very creative techniques giving persons rights of withdrawal who otherwise had no direct beneficial interest in the Trust.

Congress has finally come to the rescue of the Internal Revenue Service by amending IRC §2511 which is effective for gifts after December 31, 2009. Any gift made after that time which is made to a trust will be a taxable gift. The only exception is a gift which is made to a trust which is part of the estate of the giver.

Will there be a need for wealth replacement insurance? If the answer is yes, will continuation of an irrevocable trust to be the owner and beneficiary of the insurance be the appropriate medium? If the answer to that question is yes, should there be additional funding of the trust be made prior to December 31, 2009? Should funding of all irrevocable trusts whether or not they have been established for the benefit of acquiring and maintaining policies of life insurance be re-examined? If current funding is less than the per donee annual exclusion, should these trusts now be funded to the maximum amount? Should the death benefit under a wealth replacement policy be reduced because of the increases in the Applicable Exclusion Amount? I have already specifically advocated this approach with the first client that has posed this question.

Each person will be required to address these items on an individual basis. Perhaps the only subject which might be worth of addressing currently would be "over funding" of an irrevocable trust. If this is an appropriate course to pursue initiating this approach could be considered as earlier as possible including the current year.

The repeal of Crummey trusts after 2009 may be the impetus to creating new ones now irrespective of wealth replacement. As a general rule, only sloppy attention to details ever resulted in the IRS winning any battle over qualifications of gifts to an irrevocable trust for present gift tax treatment.  

Forestry and Federal Gift Tax

Title: Forestry and Federal Gift Tax

Publication Date: May, 2002

Author(s): Michael W. Rosenberg

FORESTRY AND FEDERAL GIFT TAX
Christine M. Hackl v., Commissioner, 118 T.C. No. 14 
filed March 27, 2002

Repeatedly in prior articles and numerous private consultations this office has strongly recommended the implementation of a lifetime giving program (see Gifts of Non-Publicly Traded Shares and Family Limited Partnerships) as an effective means of transferring wealth from one generation to one or more younger generations without the imposition of any excise tax either at the time of the gift or subsequently by reason of the death of the giver. The goal which is sought to be achieved from the standpoint of the giver is to transfer assets which would otherwise pass at the time of death and be taxable at the time of death. When the transfer can be made within limits of the per donee annual exclusion the family of the giver and the recipients have saved both the federal estate tax and the local estate tax (if there is a local estate tax or equivalent in the state of domicile). Furthermore, when the appropriate property has been selected the ultimate savings will be more than the federal estate tax on the given item at the time of the gift. If the gift property appreciates in value the tax savings apply to both the property at the time of the gift and the increased value of the property at the time of death.

The general limit of widespread lifetime giving is the per donee annual exclusion. Before 1986 this was $3,000 per person. It increased as part of the Tax Reform Act of 1986 to $10,000. As part of the Taxpayer Relief Act of 1997 the per donee annual exclusion along with certain other monetary limitations is tied to post-1998 increases in the Consumer Price Index. The increases are in $1,000 increments and the first such increase became effective for gifts made after December 31, 2001 so that the per donee annual exclusion is now $11,000. For the time frame which is discussed in Hackl, the per donee annual exclusion was $10,000.

Mr. and Mrs. Hackl were an ideal couple to make gifts. They had eight children, apparently all with good marriages since the in-laws were included in the class of persons that received the gifts along with 25 grandchildren. Therefore, Mr. and Mrs. Hackl could each make gifts of $410,000 per year to the entire class within the limits of the per donee annual exclusion. The 1995 gifts were made only to children and their spouses. Thereafter annual gifts to children, spouse and grandchildren were made in each year from 1996 to 1999. A form of double whammy ultimately befell Mr. and Mrs. Hackl. The IRS never challenged the gift tax return for 1995. When 1996 was audited, the Hackls and the IRS agreed that the disposition of the 1996 gifts would cover all gift years.

A second device which was present in the Hackl case was a creation of a family enterprise. Traditionally this would have been a family limited partnership. The Hackls used a family limited liability company managed by Mr. Hackl. The gifts that were made by the Hackls in each year consisted of units of the family limited liability company. Consistent with standard practice (see Gifts of Non-Publicly Traded Shares) valuation discounts were taken. As part of the stipulations, as described below, this was not another valuation case because both the IRS and the Hackls agreed upon the value of each unit. There is a fallback when a gift does not qualify for the per donee annual exclusion. This is the lifetime Applicable Exclusion Amount. The Applicable Exclusion Amount applies when gifts are made in excess of the per donee annual exclusion or constitute a "future interest". Currently this amount is $1,000,000 as a result of the Economic Growth and Tax Relief Reconciliation Act of 2001. For the years of the Hackl gifts it was an amount of $650,000 or less.

The limited liability company formed by Mr. and Mrs. Hackl followed all the usual guideposts. Mr. and Mrs. Hackl each owned 50% at the outset. Management was retained by Mr. Hackl. The Manager had wide sweeping authority. Some of his powers may have been beyond the norm. As discussed below, the form of the Operating Agreement should not prevent any taxpayer losing a similar case in the future. The units they gave away had limited voting rights since they were subject to an Operating Agreement which reserved substantial authority to Mr. Hackl and any successor he would select. The Hackls may have gone too far in overly restricting potential resale since the management would have the authority to establish the price for units for any potential resale to a third party. Normally, this type of restriction constitutes a right of first refusal to current unit owners at the third party offer price.

Ultimately, the failure of this aspect of the Hackl estate plan pertained to the business of the limited liability company. Mr. and Mrs. Hackl wanted to grow trees. At the time of the formation of the limited liability company two substantial multi-thousand acre parcels of real estate located in two different states were acquired. The purpose of the parcels was to grow trees which ultimately would be harvested for lumber and lumber products. In addition to the two original sites, Mr. and Mrs. Hackl also contributed a substantial amount of money and securities. The purpose of the cash contribution was to enable the limited liability company to acquire a third site and provide working capital for the planting of trees on all sites, their nurturing, management and ultimate sale. Mr. Hackl devoted hundreds of hours each year to the business of the limited liability company. Between 8 and 10 million trees were planted. Georgia-Pacific and another forest products company were hired to manage the properties.

From hindsight, the Tax Court concluded that any transfer of property to constitute a "present" and not a "future" interest must not only have value at the time of transfer, but must also simultaneously generate income to the recipient. The phrasing of the opinion results in the transfer of property to constitute a present interest must provide "substantial present economic benefit". Detailed budgets and forest management plans were developed by the consulting companies which recognized a lack of current income, but glowing future prospects were projected including appreciation and the harvesting of lumber products. The only shortcoming is that the Hackls fully understood and stated that no income would be generated by the limited liability company for a number of years. In fact, during each year through 2000 the limited liability company had generated losses since only expenses were incurred and the tree farms did not generate income from sale of trees..

This is the foundation for the decision by the Tax Court. The Tax Court concluded that notwithstanding the assignment of a value to the units, the gift of the units by Mr. and Mrs. Hackl did not constitute a present interest and in the language of §2503(b) were "gifts of future interests in property"…"Furthermore, it has become well settled that to qualify as a present interest, such a gift must confer on the donee not just vested rights but a substantial present economic benefit by reason of use, possession or enjoyment of either the property itself or income from the property". 118 T.C. No. 14 at page 17 citing Fondren v. Commissioner, 324 U.S. 18 (1945). The Court later uses the language that a gift must have a "present (not postponed) economic benefit". There were two different lines of thought which lead to this conclusion. The first was the retained ability of Mr. Hackl as manager to determine distributions of cash, allow transfers, and establish value upon resale. This aspect of the discussion is directly related to the provisions of the Operating Agreement. It can be classified as an organizational defect. The restrictions placed on the Units prevented the children, etc. from having any right to realize any economic benefit from ownership. Specifically the approval of the Manager, which could be refused, was required for sale to a third party. The Manager could not be compelled to make distributions. No capital could be withdrawn, etc. The Hackls argued that these are standard features of family limited liability company documents and the custom in the timber growing industry. This argument was wholly rebuffed by the Tax Court stating that federal law principles determine matters of the tax aspects of the transfer of ownership interests in property or entities.

The second and more pervasive reason which has a stronger foundation in prior case law, was the lack of income which was being currently realized and for the foreseeable future. The Tax Court concluded that any transfer of property to constitute a "present" and not a "future" interest must not only have value at the time of transfer, but must also simultaneously generate income to the recipient. The phrasing of the opinion results in the transfer of property to constitute a present interest must provide "substantial present economic benefit". If the Hackls were growing trees in our climate the analogy would be that though mighty oaks can grow from mere acorns and forty years is required to complete that journey, a gift of an interest in the ground that will nurture the acorn does not qualify as a present interest.

Is the Tax Court wrong? Going back as far as lawyers in this firm can remember, gifts have been made without challenge by the IRS of property which does not generate income and which cannot be turned into cash the next day by the recipient. Examples of these consist of vacation homes, private islands, shares in family owned C corporations which do not pay dividends, works of art, undeveloped land, personal residence, etc. It is most perplexing that the IRS and the taxpayers agreed that the units had value and further concurred to the penny on the value per unit. The consternation on faces of counsel for the taxpayer when they reach this part of the opinion and yet to have the trap door quickly opened beneath their collective feet should have been heart stopping.

The organizational aspects of the Hackl LLC can easily be addressed. A commentator has already published an article listing an alternative method of dealing with a Hackl fact situation of loss property through an alternative planning device consisting of sale to a defective grantor trust. Clearly Hackl will be appealed and the briefs of the friends of the court which will be filed on behalf of the taxpayer should be extensive. After all does not part of the Hackl opinion extend to that most basic of estate planning documents which is the creation of an Irrevocable Trust to own a policy of life insurance, especially a term policy? Until Hackl is further decided, anyone making a gift of property which has the same characteristics as the tree farms must give due regard to this line of attack. The bright line of Hackl clearly states, either the given property itself or the income from the given property must produce a "presently reachable economic benefit", 118 T.C. No. 14 at 28. At the least, all draftsmen of limited liability Operating Agreements will not fail the organizational test in the future. The restrictions placed upon free transferability of units, etc. will be scaled back. Alternatively, if the subject matter of the gift does generate annual income and it (or a significant portion) is distributed, Hackl appears to condone even the most restrictive imaginative provisions permittable in the Operating Agreement.  

Forestry and Federal Gift Tax

Title: Forestry and Federal Gift Tax

Publication Date: May, 2002 and revised October, 2003

Author: Michael W. Rosenberg

FORESTRY AND FEDERAL GIFT TAX

Christine M. Hackl v., Commissioner, 118 T.C. No. 279 (2002)

aff'd 335 F3d 664 (7th Cir. 2003)

Repeatedly in prior articles and numerous private consultations this office has strongly recommended the implementation of a lifetime giving program (see Gifts of Non-Publicly Traded Shares and Family Limited Partnerships) as an effective means of transferring wealth from one generation to one or more younger generations without the imposition of any excise tax either at the time of the gift or subsequently by reason of the death of the giver. The goal which is sought to be achieved from the standpoint of the giver is to transfer assets which would otherwise pass at the time of death and be taxable at the time of death. When the transfer can be made within limits of the per donee annual exclusion the family of the giver and the recipients have saved both the federal estate tax and the local estate tax (if there is a local estate tax or equivalent in the state of domicile). Furthermore, when the appropriate property has been selected the ultimate savings will be more than the federal estate tax on the given item at the time of the gift. If the gift property appreciates in value the tax savings apply to both the property at the time of the gift and the increased value of the property at the time of death.

The general limit of widespread lifetime giving is the per donee annual exclusion. Before 1986 this was $3,000 per person. It increased as part of the Tax Reform Act of 1986 to $10,000. As part of the Taxpayer Relief Act of 1997 the per donee annual exclusion along with certain other monetary limitations is tied to post-1998 increases in the Consumer Price Index. The increases are in $1,000 increments and the first such increase became effective for gifts made after December 31, 2001 so that the per donee annual exclusion is now $11,000. For the time frame which is discussed in Hackl, the per donee annual exclusion was $10,000.

Mr. and Mrs. Hackl were an ideal couple to make gifts. They had eight children, apparently all with good marriages since the in-laws were included in the class of persons that received the gifts along with 25 grandchildren. Therefore, Mr. and Mrs. Hackl could each make gifts of $410,000 per year to the entire class within the limits of the per donee annual exclusion. The 1995 gifts were made only to children and their spouses. Thereafter annual gifts to children, spouse and grandchildren were made in each year from 1996 to 1999. A form of double whammy ultimately befell Mr. and Mrs. Hackl. The IRS never challenged the gift tax return for 1995. When 1996 was audited, the Hackls and the IRS agreed that the disposition of the 1996 gifts would cover all gift years.

A second device which was present in the Hackl case was a creation of a family enterprise. Traditionally this would have been a family limited partnership. The Hackls used a family limited liability company managed by Mr. Hackl. The gifts that were made by the Hackls in each year consisted of units of the family limited liability company. Consistent with standard practice (see Gifts of Non-Publicly Traded Shares) valuation discounts were taken. As part of the stipulations, as described below, this was not another valuation case because both the IRS and the Hackls agreed upon the value of each unit. There is a fallback when a gift does not qualify for the per donee annual exclusion. This is the lifetime Applicable Exclusion Amount. The Applicable Exclusion Amount applies when gifts are made in excess of the per donee annual exclusion or constitute a "future interest". Currently this amount is $1,000,000 as a result of the Economic Growth and Tax Relief Reconciliation Act of 2001. For the years of the Hackl gifts it was an amount of $650,000 or less.

The limited liability company formed by Mr. and Mrs. Hackl followed all the usual guideposts. Mr. and Mrs. Hackl each owned 50% at the outset. Management was retained by Mr. Hackl. The Manager had wide sweeping authority. Some of his powers may have been beyond the norm. As discussed below, the form of the Operating Agreement should not prevent any taxpayer losing a similar case in the future. The units they gave away had limited voting rights since they were subject to an Operating Agreement which reserved substantial authority to Mr. Hackl and any successor he would select. The Hackls may have gone too far in overly restricting potential resale since the management would have the authority to establish the price for units for any potential resale to a third party. Normally, this type of restriction constitutes a right of first refusal to current unit owners at the third party offer price.

Ultimately, the failure of this aspect of the Hackl estate plan pertained to the business of the limited liability company. Mr. and Mrs. Hackl wanted to grow trees. At the time of the formation of the limited liability company two substantial multi-thousand acre parcels of real estate located in two different states were acquired. The purpose of the parcels was to grow trees which ultimately would be harvested for lumber and lumber products. In addition to the two original sites, Mr. and Mrs. Hackl also contributed a substantial amount of money and securities. The purpose of the cash contribution was to enable the limited liability company to acquire a third site and provide working capital for the planting of trees on all sites, their nurturing, management and ultimate sale. Mr. Hackl devoted hundreds of hours each year to the business of the limited liability company. Between 8 and 10 million trees were planted. Georgia-Pacific and another forest products company were hired to manage the properties.

From hindsight, the Tax Court concluded that any transfer of property to constitute a "present" and not a "future" interest must not only have value at the time of transfer, but must also simultaneously generate income to the recipient. The phrasing of the opinion results in the transfer of property to constitute a present interest must provide "substantial present economic benefit". Detailed budgets and forest management plans were developed by the consulting companies which recognized a lack of current income, but glowing future prospects were projected including appreciation and the harvesting of lumber products. The only shortcoming is that the Hackls fully understood and stated that no income would be generated by the limited liability company for a number of years. In fact, during each year through 2000 the limited liability company had generated losses since only expenses were incurred and the tree farms did not generate income from sale of trees..

This is the foundation for the decision by the Tax Court. The Tax Court concluded that notwithstanding the assignment of a value to the units, the gift of the units by Mr. and Mrs. Hackl did not constitute a present interest and in the language of §2503(b) were "gifts of future interests in property"…"Furthermore, it has become well settled that to qualify as a present interest, such a gift must confer on the donee not just vested rights but a substantial present economic benefit by reason of use, possession or enjoyment of either the property itself or income from the property". 118 T.C. No. 14 at page 17 citing Fondren v. Commissioner, 324 U.S. 18 (1945). The Court later uses the language that a gift must have a "present (not postponed) economic benefit". There were two different lines of thought which lead to this conclusion. The first was the retained ability of Mr. Hackl as manager to determine distributions of cash, allow transfers, and establish value upon resale. This aspect of the discussion is directly related to the provisions of the Operating Agreement. It can be classified as an organizational defect. The restrictions placed on the Units prevented the children, etc. from having any right to realize any economic benefit from ownership. Specifically the approval of the Manager, which could be refused, was required for sale to a third party. The Manager could not be compelled to make distributions. No capital could be withdrawn, etc. The Hackls argued that these are standard features of family limited liability company documents and the custom in the timber growing industry. This argument was wholly rebuffed by the Tax Court stating that federal law principles determine matters of the tax aspects of the transfer of ownership interests in property or entities.

The second and more pervasive reason which has a stronger foundation in prior case law, was the lack of income which was being currently realized and for the foreseeable future. The Tax Court concluded that any transfer of property to constitute a "present" and not a "future" interest must not only have value at the time of transfer, but must also simultaneously generate income to the recipient. The phrasing of the opinion results in the transfer of property to constitute a present interest must provide "substantial present economic benefit". If the Hackls were growing trees in our climate the analogy would be that though mighty oaks can grow from mere acorns and forty years is required to complete that journey, a gift of an interest in the ground that will nurture the acorn does not qualify as a present interest.

Is the Tax Court wrong? Going back as far as lawyers in this firm can remember, gifts have been made without challenge by the IRS of property which does not generate income and which cannot be turned into cash the next day by the recipient. Examples of these consist of vacation homes, private islands, shares in family owned C corporations which do not pay dividends, works of art, undeveloped land, personal residence, etc. It is most perplexing that the IRS and the taxpayers agreed that the units had value and further concurred to the penny on the value per unit. The consternation on faces of counsel for the taxpayer when they reach this part of the opinion and yet to have the trap door quickly opened beneath their collective feet should have been heart stopping.

The Seventh Circuit Court of Appeals affirmed the decision of the Tax Court. On appeal, the Hackls argued that "present" interest means a transfer of all legal rights and interests in the subject matter of the gift. This position has its foundation in the case law of real property. If all legal rights are transferred, the giver has not retained any "strings". Therefore, the recipient is entitled to immediate enjoyment and has received a present interest. If anything would have to occur in the future in order for full enjoyment to be realized, the transferred item would be a future interest.

Part of the Hackl argument was technically based on the relevant section of the Internal Revenue Code and completely disregarded the applicable Treasury Regulations promulgated under §2503. The Supreme Court and the Seventh Circuit had previously applied the regulations in earlier cases dealing with the definition of present interest in the gift tax area. Thus, this line of attack was doomed from the outset.

The Seventh Circuit rejected the interpretation of "present" versus "future" interest advanced by the Hackls quoting its decision in Stinson Estate v. U.S. 214 F3d 846 (7th Cir. 2000). The "... sole statutory distinction between present and future interests lies in the question of whether there is postponement of enjoyment of specific rights, powers or privileges which would be forthwith existent if the interest were "present". Id at 848-49. If reiterated this holding by citing the Fondren decision which was the crux of the Tax Court opinion.

The organizational aspects of the Hackl LLC can easily be addressed. A commentator has already published an article listing an alternative method of dealing with a Hackl fact situation of loss property through an alternative planning device consisting of sale to a defective grantor trust. After all does not part of the Hackl opinion extend to that most basic of estate planning documents which is the creation of an Irrevocable Trust to own a policy of life insurance, especially a term policy? Since the 7th Circuit has affirmed Hackl on all major issues, anyone making a gift of property which has the same characteristics as the tree farms must give due regard to this line of attack. The bright line of Hackl clearly states, either the given property itself or the income from the given property must produce a "presently reachable economic benefit", 118 T.C. No. 279 at 28. At the least, all draftsmen of limited liability Operating Agreements will not fail the organizational test in the future. The restrictions placed upon free transferability of units, etc. will be scaled back. Alternatively, if the subject matter of the gift does generate annual income and it (or a significant portion) is distributed, Hackl appears to condone even the most restrictive imaginative provisions permittable in the Operating Agreement.

When a Leopard Can Change Its Spots

Title: PLR 200326024 and the Evolution of the "Check-the-Box" Regulations

Publication Date: Sept., 2003

Author(s): Michael W. Rosenberg

All of us since we were little children have been told that leopards have spots and tigers, stripes. Furthermore, the axiom that "a leopard cannot change spots" is generally understood to me that although surface and cosmetic changes can be made the ultimate essence of a person cannot be modified. Thus, a leopard will never become a tiger. This proposition may no longer hold true for federal income tax matters. PLR 200326024, (the "PLR") ultimately allows a partnership (the leopard) to be taxed as an S corporation (a tiger).

Leaving apart certain provisions of the Internal Revenue Code which apply to very specific entities, i.e., a mutual fund, there are four basic types of tax entities. These consist of an individual, a partnership, a trust and a corporation. Each one of them is governed by a separate subchapter of the Code. A corporation with the consent of its shareholders and if it is eligible and its shareholders are otherwise qualified, can elect not to be taxed under the provisions which apply to corporations. In that instance the corporation is a qualifying small business corporation and can elect to be taxed as an S corporation. When that election has been made the items of income, expense, gain and loss are reported to the shareholders. The shareholders then recognize these items on their individual returns. When this election has been made the corporation is an "S corporation" and becomes generally a pass-through entity because tax is not imposed at the corporate level.

This is the parallel procedure which generally applies to most trusts and partnerships. To the extent that a trust makes distribution of income, the recipient of the income has received taxable income and the trust has a deduction. The trust is taxed on undistributed income. A partnership is another pass-through entity. No tax is ever paid by a partnership at the partnership level. All items of income, deduction, gain and loss are separately reported by the partners.

A third basic element arose with the creation of the concept of a disregarded entity. This occurs in three different situations, two of which are germane to the discussion of PLR and its holding. If there is a single member limited liability company (a "SMLLC"), for federal income tax purposes the SMLLC is not a separate tax reporting entity. It does not file a separate return. It does not have a separate taxpayer identification number. If it has employees it has an employer identification number. All of its income, deduction, gain and loss are reported on the appropriate schedule of its owner. This same reporting consequence applies for a corporation which is a subsidiary of an S corporation. The subsidiary is designated as a "Q-Sub". It does not file a separate tax return. All of its income, deduction, gain or loss is combined with similar items of its parent corporation on the tax return of the parent.

Another alternative has long been available to a partnership. It could make an election to be classified as an association and taxable as a corporation. Prior to the adoption of the "check the box" regulations, primarily in the 1970's and the 1980's this was always the sword held by the Internal Revenue Service over the neck of partnerships and especially limited partnerships. Limited partnerships had to be very carefully drawn in order to preserve the status of qualification for partnership taxation. The consequences of being an association taxable as a corporation meant taxation at the corporate level. In a start-up situation, losses would be realized by the partnership and could not be passed through to the partners (usually investors in a real estate project or natural gas well drilling program). Furthermore, any distributions which would constitute income would be both income at the corporate level and then dividends to the partners, the feared and dreaded consequences of double taxation. In the background of the pre-2003 Tax Act, double taxation of dividends could mean taxed at the corporate level of almost 40% and then at the individual level of almost the same amount. In this regime a partnership was the leopard and the corporation was the tiger. They never would be confused. The treatment of a partnership which either elected to be taxed as an association or was determined to be an association meant the passing over the line from a pass-through entity to an entity which was totally taxed at the entity level.

It is against this background that the PLR was issued. The taxpayer originally submitted its request for ruling to the Internal Revenue Service on June 6, 2002. The PLR was finally issued on March 14, 2003. It was released by the Internal Revenue Service on June 27, 2003 and was published thereafter. It describes a very complicated transaction. The taxpayer is a corporation which elected to be treated as an S corporation. The corporation had only one shareholder. The PLR states that for business reasons the shareholder would organize a new limited liability partnership and a new limited liability company. The shareholder would be the sole owner of the new limited liability company. The shareholder will capitalize the limited liability company by transfer of ownership of a percentage interest in the new limited liability partnership. The limited liability partnership will make an election to be classified as an association taxable as a corporation. A further election is made that the limited liability partnership will elect to be taxed as an S corporation. The shareholder then contributes all of the stock of the corporation to the new limited liability partnership. As such the corporation now becomes a subsidiary of the new limited liability partnership. The limited liability partnership elects to treat the corporation as a Q-Sub. The limited liability partnership will form a limited liability company with the limited liability partnership being the sole owner of the limited liability company. Lastly, the limited liability partnership transfers stock of the corporation to the limited liability company. The last step is that the original corporation converts under state law from a corporation to a limited partnership. After the conversion the limited liability company is a general partner and the limited liability partnership is the limited partner. All these activities are represented in the diagrams that follow.

A – an individual who is sole shareholder of X and sole owner of LLC

X – corporation which has elected to be taxed as an S corp.

Y – a limited liability partnership

LLC – a limited liability company

Z – a second limited liability company

STEP 1 – A is current owner of X, forms Y and LLC, transfers part of Y to LLC

Y elects (a) to be an association taxable as a corporation; (b) to be an S corp.

STEP 2 – A transfers all X to Y, Y elects to treat X as a QSub

STEP 3 - Y forms Z and transfers part of X to Z

STEP 4 – X converts from corporation to limited partnership – Z becomes general partner and Y will be limited partner.

The substantial issues addressed in the PLR continued to cross-over the dividing lines between partnership and S corp. taxation. Holdings were made that the provisions of the limited partnership agreement of Y did run contrary to the statutory requirements for an S. corp. A representation had to be made that the total partners would not exceed that statutory limits for permitted number of shareholders in an S corp. The final holding approved the series of steps which constituted the entire transaction. In stating the relevant law, the PLR quotes the Treasury Regulations as follows:

"Section 301.7701-3(a) provides that a business entity that is not classified as a corporation under sections 301.7701-2(b)(1), (3), (4), (5), (6), (7) or (8) (an eligible entity) can elect its classification for federal tax purposes as provided in section 301.7701-3. An eligible entity with at least two members can elect to be classified as either an association (and thus a corporation under section 301.7701-2(b)(2)) or a partnership, an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity apart from its owner.

Section 301.7701-3(b)(1)(ii) provides that the absence of election to be taxed as an association, a domestic eligible entity with a single member will be disregarded as an entity separate from its owner if it has a single owner."

The PLR ends with the normal language which appears in each private letter ruling. It is directed only to the taxpayer that requested it. It may not be used or cited as precedent. There are a number of peripheral issues in the PLR all of which were resolved to the satisfaction of the taxpayer. The broad implication is the determination that any association or any entity which elects to be taxed as an association can make a further election to be taxed as an S corporation and therefore can structure its federal taxation in any manner that it wishes. The transaction began with one corporation and one shareholder. In essence it ends up with one shareholder and one entity. All the other entities are disregarded entities. The limited liability partnership which becomes the ultimate taxpayer is a device. The person who owned the shares of the corporation owns the entities which constitute the partners of the limited liability partnership. All intervening entities are either pass through or are disregarded entities.

There are situations in which it is more beneficial for federal income tax purposes to be an S corporation as opposed to a totally disregarded entity. Principally these arise in the area of employment tax and Medicare tax. The PLR is illustrative of a method which can be utilized in appropriate circumstances to radically reorganize business holdings and at the completion of the activities to be able to totally choose the form of ultimate taxation. An essential element is the qualification to be an association. This requires two persons. However, the persons can be disregarded entities and can change their tax status during or at the end of the series of transactions. This is the ultimate consequence of the "check-the-box" regulations which permits the taxpayer the opportunity to select its form of federal tax identity.

Healthcare Reimbursement Accounts

Title: Expanding the Use of Health Reimbursement Accounts

Publication Date: October 2003

Author(s): Michael W. Rosenberg

EXPANDING THE USE OF HEALTH REIMBURSEMENT ACCOUNTS REV. RUL. 2003-012

The health care industry has many deficiencies which include rocketing increases in health care insurance premiums, prescription drug costs which approach unconscionable levels, unaffordable malpractice insurance premiums for many doctors in many areas and numerous other maladies too extensive to catalog. Legislative inaction has abided for many years. From the stand point of the Internal Revenue Code, health care expenses have always had the status of the proverbial unwanted stepchild. While certain types of expenses are fully deductible for individual taxpayers who itemize their deductions (i.e., interest on a home mortgage below $1,000,000 and real estate taxes), a floor has always been imposed on the deductibility of health care expenses. The current floor is 7½% of adjusted gross income. For a taxpayer whose adjusted gross income is $40,000, the taxpayer is the self-insurer for the first $3,000 of medical expenses.

The most common way that an individual receives health care insurance benefits is through a plan sponsored by the employer. Years ago when health insurance premiums were substantially lower and the cost of which would have amounted to less than $1 per working hour per month, the general trend was that the employer would pay the full cost of the health insurance premium. This was a true fringe benefit to all employees. The employee (if married with children), together with the spouse and dependents, would receive a benefit which is fully funded by the employer. The cost was deductible to the employer and no part of the benefit was imputed to be income to the employee. As the cost of health care insurance began to rise, employers who were still financially able to provide coverage to employees ultimately required the employees to assume burden of a payment of a portion of the health insurance cost. As described at the beginning of this article, while payment of premium for health insurance is a deductible medical expense, because of the 7½% floor generally the payment became non-deductible. Any expenditure which is non-deductible is made "after tax". If the total local, state and federal income tax rate is 33% an employee would have to earn $150 in order to pay all the applicable taxes in order to have $100 available for premium.

A method has long existed to make the employee contribution to the payment of health insurance a "deductible expense". The basic framework is established under §125 as a "cafeteria plan". An employee is given the option to receive cash or one of a list of deferred benefits. To the extent that a deferred benefit is elected, the employee is not considered to have received income. A rigid set of rules applies to provide that the income deferred is not construed to be constructively received. If there is constructive receipt, then the employee is currently taxed whether or not the income is actually received. The formal elements of establishing a cafeteria plan included adoption of an enabling resolution by the governing group of the employer, publication of a formal plan, distribution of an extensive notice to employees, creation of a wage deferral agreement, and execution by the employee of the wage deferral agreement. The applicability of constructive receipt was forestalled by taking all of these steps before the services were rendered by the employee to the employer for which the deferred compensation would be payable. These have been widely implemented for payment of health care policy premiums under a §125 "premium only" plan. The employer would reduce the compensation of the employee by $100 per month. The reduced compensation would then be used by the employer to pay the employee portion of the health insurance. This is a situation which benefits both the employee and the employer. The employee saves the income tax as described above. The employer also realizes a savings because the reduction of compensation of $100 reduces the obligation of the employer to both withhold the FICA tax and Medicare tax and making a matching contribution. The employee also realizes the same FICA and Medicare tax savings.

The statutory framework for the undertaking is §105 of the Internal Revenue Code of 1986, as amended. There is a second aspect of §105 which has received extensive attention by the Internal Revenue Service in the past year in the form of Revenue Rulings. The applicable language of §105(b) read as follows:

"... gross income does not include amounts referred to in subsection (a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by him for the medical care (as defined in section 213(d) of the taxpayer, his spouse and his dependents..."

The reference to §105(a) establishes the general rule of §105 creates an exclusion for amounts received from insurance proceeds which "are attributable to contributions by the employer which were not includible in the gross income of the employee".

As an aside there is a certain disingenuousness in the treatment of employer funding created by employee deferrals. In the technical sense, employer funds pay the premium. However, the source is foregone compensation by the employee. The employee had to render the services to earn the compensation. In other areas of federal taxation both the IRS and the courts have applied the step-transaction doctrine to treat an entire series of interrelated activities as one undertaking. This, to the benefit of employers and employees does not occur in this area. As a result the foregone compensation is treated as the property of the employer.

Not only could an employee voluntarily agree to reduce compensation for payment of premium but a further reduction could be authorized for the payment of medical expenses. These are the expenses that are incurred for medical care which are not covered by insurance. The 7½% floor described above again constitutes a substantial barrier to deductibility of these amounts. Therefore, the employee by further reducing compensation could make "deductible" medical expenses which otherwise would not be deductible. The steps to implementing this aspect of a §105 plan would include the following:

1. Prior to the time that any medical expense would be incurred, the employee would enter into a compensation reduction agreement with the employer.

2. On a regular periodic basis, a recurring amount would be withheld from the compensation of the employee.

3. During the year of withholding the employee would incur expenses.

4. The employee upon submission of paid bills would be reimbursed by the employer up to the maximum amount that would be withheld from the compensation of the employee during the year.

5. Any amounts not expended during the year by the employee for allowable health care expenses would be forfeited.

This last "use it or lose it" feature often was a practical detriment to the implementation of a §105 plan that would include reimbursement for medical expenses. Now plans can provide for a rollover of unused amounts from one year to the next. The only true forfeiture will now occur upon termination of employment with a balance remaining in the account.

The Internal Revenue Service has published a series of Revenue Rulings which now greatly broaden the appeal of medical reimbursement accounts. The three principal announcements by the Internal Revenue Service are as follows:

1. Rev. Rul. 2003-43 ruled that medical expense reimbursements which are made by means of either a debit or credit card under a flexible spending account or health reimbursement arrangement would be excludible from the income of employees. The criteria of proper documentation of medical expense would still be required. This Ruling eliminated the need for the employee to first make actual payment before securing reimbursement. The IRS had previously ruled in 2002 that two different marketing schemes of giving the employee immediate access to the deferred account were ineffective because of the reimbursement required, i.e., the expense must actually be incurred before payment (reimbursement) could be made. It is a further benefit to the health care provider because the debit card would result in immediate payment from the funding made by the employer for the service provided by the health care provider to the employee.

2. Rev. Rul. 2003-58 published on May 15, 2003 ruled that non-prescription medical supplies do not qualify as deductible medical expenses. Examples of these are antacid and allergy medicine, pain reliever, and a cold medicine. All of these are purchased without a prescription. Section 213 is limited to "medical care", amounts paid for diagnosis, cure, medication, treatment or prevention of disease or for the purpose of effecting any structure or function of the body. Within the context of §213, the cited examples of cold medicine, etc. are merely beneficial to the general health of the individual and do not constitute medical care. Rev. Rul. 2003-58 analyzed non-prescription drugs and medicines solely within the context of §213.

3. Rev. Rul. 2003-102 published on September 3, 2003 distinguished Rev. Rul. 2003-58. It specifically addresses the same types of remedies and supplies discussed in Rev. Rul. 2003-58. It held that all of these items are use to alleviate or treat personal injuries or sickness. In its holding, the IRS concluded that the exclusion under §105(b) refers only to expenses incurred for medical care. The language of §105(b) does not require that the expense must be allowed as a deduction for medical care under §213 or that only medicines and drugs that require a physician's prescription must be taken into account.

This is truly extraordinary. Leave aside the 7½% floor issue. If a taxpayer buys a bottle of Advil, the expense is non-deductible. Before playing for the headache medicine, the taxpayer paid income tax, FICA and Medicare tax. The employer also paid FICA and Medicare. If the employer had a medical reimbursement plan in effect, all the described taxes are eliminated and the same purchase which was not previously deductible if directly financed becomes deductible when the medium of a medical reimbursement account is introduced.

While some serious head scratching may be undertaken by readers, the benefits are obvious. Almost everyone on a continuing basis buys non-prescription drugs. This also has a ripple effect. Drugs which once were subject to prescription become generic and no longer require a prescription. In order to receive the benefit of the recent series of Revenue Rulings, any employer which has in place a §105(b) plan must determine whether or not the reimbursement of the plan is limited to items which are classified as medical expenses under §213. This was the usual language contained in plans. If the plan does contain that feature the plan will have to be amended to take into consideration the pronounced dichotomy between §105 medical care and §213 medical expenses. There have also been other health related events which have received IRS blessing this year as constituting "medical expenses", including weight reduction programs, treatments and surgery together with employing personal fitness trainers. Therefore, even though Congress has been unable to attend to the major policy issues, the IRS on an administrative basis appears to be exerting every effort to ease the after tax cost of health care.

Health Reimbursement Arrangements

Title: Fighting the Rising Tide of Unending Escalating Health Care Costs with a Toddler's Sand Bucket and Shovel

Publication Date: November, 2002

Author(s): Michael W. Rosenberg, Marsha J. Weiss, Esq.

HEALTH REIMBURSEMENT ARRANGEMENTS FIGHTING THE RISING TIDE OF UNENDING ESCALATING HEALTH CARE COSTS WITH A TODDLER'S SAND BUCKET AND SHOVEL

In Rev. Rule 2002-41 and Notice 2002-45 which were simultaneously published by the Internal Revenue Service in 2002-28 IRB on June 26, 2002, the Internal Revenue Service has provided another weapon to lessen the after tax cost of medical expenses and health care insurance. As a general rule, any premium for health care coverage and medical expense paid by an employer for an employee is a deductible business expense to the employer and is not income to the employee. Conversely, if the employee pays any medical expense or health care premium, that payment constitutes a deductible medical expense under §213 only if the employee itemizes deductions and if the premiums and medical expenses exceed 7½% of adjusted gross income. The net effect of itemization and exclusion of the first 7½% of expenses (except in rare situations) is to make health care expenses an after-tax event to the employee. Consequently, employer provided health insurance and payment of medical expenses are extremely valuable fringe benefits to any employee.

For more than a decade costs of health care, the breadth of coverage, insurance availability and costs of health insurance have been prominent concerns throughout the United States. During this period premiums have risen dramatically, major medical plan deductibles have been increased in an attempt to limit premium cost, fewer insurers populate the market, more persons have no coverage at all, and many employers limit employee hours so that employees do not qualify for employer provided health insurance. In an effort toward cost containment, employers providing a plan pay only a certain percentage of the insurance coverage. The employee must pay the balance of the premium. In order to make this a pre-tax expense to the employee, §125 has permitted an employer to create a "cafeteria plan". A cafeteria plan allows an employee to receive either cash or one or more non-cash benefits. When the employee elects a benefit, it is funded by salary reduction. In its simplest and most widely adopted form, the salary reduction under a cafeteria plan for health care costs is limited to "premium only". The amount withheld from the compensation of the employee equals the amount which the employee must pay for the health insurance coverage.

A premium only cafeteria plan benefits both the employer and the employee. While it still remains a deductible expense to the employer, the amount of the salary is not income subject to employment taxes. The salary reduction is not considered to be earned income for the employee for federal tax purposes. Therefore, the savings to the employee is his or her share of FICA and Medicare tax plus the federal income tax that would be imposed on the amount of the salary reduction. Since the Ohio income tax is based on federal adjusted income, the average Ohio taxpayer's savings are approximately 40% (7.65% FICA and Medicare; 28%, federal income tax; and 4%, Ohio income tax). Therefore, payment of $100 monthly premium under a premium only plan on a before tax basis is the equivalent of receiving $170, paying all the above taxes and covering the same premium.

Another variation is the establishment of a flexible spending account ("FSA"). Under an FSA, the employee would further reduce compensation by an amount in addition to the employee portion of the health insurance premium. The amount in the FSA could be used for the payment of other expenses which qualify as deductible medical expenses under §213. A shortcoming to an FSA is that any amount withheld in any particular year has to be spent during that year for medical expenses. Any unspent amount is forfeited.

The creation of the health reimbursement arrangement ("HRA") is primarily intended to overcome the annual limitation on FSA's. Notice 2002-45 is divided into eight different subparts and the Revenue Ruling sets forth the technical requirements for the creation of an HRA. The first portion of the Notice describes the elements of an HRA. It differs from salary reduction under a cafeteria plan because the sole funding is provided by the employer. The Notice uses the following language to define and describe an HRA:

"An arrangement is not treated as an HRA if the arrangement interacts with a cafeteria plan in such a way as to permit employees to use salary reduction indirectly to fund the HRA. Therefore, where an employee who participates in a reimbursement arrangement has a choice among two or more specified accident or health plans to be used in conjunction with the reimbursement arrangement (or a choice among various maximum reimbursement amounts credited for a coverage period) and there is a correlation between the maximum reimbursement amount available under the HRA for the coverage period (disregarding amounts carried forward from previous coverage periods) and the amount of salary reduction election for the specified accident and health plan, then the salary reduction is attributed to the reimbursement arrangement even if the amount of salary reduction is equal to or less than the actual cost of the other accident or health coverage.

For example, assume an employer offers a reimbursement arrangement plus other specified accident or health plan coverage with the actual cost for family coverage for the specified accident or health plan being $4,500 and the employee having a choice to salary reduce $2,500 or $3,500 to fund this coverage. An employee who elects family coverage and $2,500 salary reduction receives a $1,000 maximum reimbursement amount under the reimbursement arrangement for the coverage period and an employee who elects family coverage and $3,500 salary reduction receives a $2,000 maximum reimbursement amount under the reimbursement arrangement for the coverage period. In this case, although the maximum allowable salary reduction is not exceeded, a portion of the salary reduction is attributed to the reimbursement arrangement because the increase in salary reduction election is related to a larger maximum reimbursement amount in the reimbursement arrangement for the coverage period. This arrangement is not an HRA and is subject to §125."

Perhaps the most important concept of an HRA is the Internal Revenue Service's determination that an HRA constitutes an FSA. Therefore, provisions which have always been applicable to an FSA still apply to an HRA. Specifically, the only expenses which can be reimbursed are those which qualify as an expense for medical care under §213(d). Each request must be substantiated. The reimbursement cannot be made (i) for an expense included in a prior year, (ii) for an expense that was incurred before the employer adopted the HRA, or (iii) the employee became enrolled under the HRA. The HRA can include premiums paid for insurance coverage for current employees, retirees and COBRA qualified beneficiaries. Conversely, to the extent that an HRA is an FSA, a medical expense which cannot be reimbursed is an expense incurred for qualified long term care services. The HRA may not be used as a disguised form of payment for any other type of compensation. The Notice lists as disqualifying payments a death benefit and a bonus related to the undisbursed amount in the HRA. Since this is an employer provided benefit, the amount which is contributed by the employer cannot be related to salary reduction or any other benefit otherwise provided under a cafeteria plan. An employer can provide both a cafeteria plan and an HRA. The Internal Revenue Service addresses this problem as follows:

The Notice lists four restrictions which are imposed on FSAs under §125 and are not applicable to an HRA. An HRA

(1) "Is funded solely by the employer and not through a salary reduction election or otherwise under a Code Sec. 125 cafeteria plan.

(2) Reimburses the employee for substantiated medical expenses (including amounts paid for premiums for accident or health coverage) incurred by current and former employees (including retirees), their spouses, and other dependents, and the spouse and dependents of deceased employees.

(3) Provides reimbursements up to a maximum stated dollar amount for a coverage period.

(4) Allows any unused portion of the maximum dollar amount at the end of a coverage period to be carried forward to increase the maximum reimbursement amount in subsequent coverage periods."

The Revenue Ruling addresses what should be the common situation. An employer provides health insurance. There is an annual deductible under the health insurance. A portion of the premium for the health insurance is paid for by employees who have elected to have a salary reduction under a premium payment only cafeteria plan. The health insurance does have annual deductibles in amounts that differ for single and family coverage. Against this background, the employer adopts an HRA. It will pay one-half of the deductible. Finally, the HRA is available only to employees who participate in the major medical plan. The IRS has ruled that this form of HRA meets the non-discrimination requirements of §105(h). A limitation under the HRA is only those medical care expenses which would be covered by the major medical plan but for the deductible. Any unused deductible in any year is carried over to a subsequent year; if, however, there is an unused portion of the deductible upon retirement, the employee does not receive any benefits.

There is an important distinction between an FSA and an HRA. Under an FSA, any deductible medical expense may be the subject of reimbursement. The HRA limits the reimbursable items to only those items which would have been covered by the employer plan "but for" the deductible. Any allowable expense under §213 not covered by the employer plan falls outside an HRA. Such item could include all forms of prescriptions and dental costs if the employer plan provides neither coverage. Many major medical plans do provide coverage for a variety of situations, including elective cosmetic surgery, (i.e., the "nips, lifts, and tucks, etc."). Consequently, an FSA which is funded from employee's money can be sued for this purpose. The HRA which is supplied by the coffers of the employer is limited to the extent of coverage under the policy. In an effort to provide cost containment, the policy itself may have been made leaner.

The Revenue Ruling also addresses COBRA coverage and contains a variable which provides that the unused amount of the deductible is still available to the retiree if the he elects to continue the COBRA coverage.

The publication of Rev. Rule 2002-41 and the accompanying Notice provide an increased incentive for employers to assist employees in coping with the continually increasing cost of health insurance and medical expenses. As described in the Revenue Ruling, linking eligibility in the HRA with participation in the major medical plan requires an employee contribution for payment of a portion of the cost of the premium for the major medical plan. This means that the employee is still required to pay a portion of the freight for medical coverage. For an employer willing to commit further dollars to health care expenses by adding the HRA and at the same time reducing a portion of the premium paid for the health insurance, an overall savings of taxes paid to the federal government could result. The employee would increase the amount of the salary reduction and thereby lessen the employment tax burden of both the employee and the employer. At the same time the employee also lessens his or her federal income tax obligation. Ultimately, the larger societal questions remain. Only an infinitesimal amount of the endless sand of health care and medical expenses can be garnered in the small bucket of an HRA.

The author acknowledges the assistance of Marsha J. Weiss, Esq. in the preparation of this Article.