REMAINING RELEVANT IN A WORLD WITH NO ESTATE

TAX:

A SURVIVAL GUIDE FOR THE ESTATE PLANNING

PROFESSIONAL

PREPARED FOR ESTATE PLANNER’S DAY

QUEENS UNIVERSITY OF CHARLOTTE

TERENCE B. STANALAND, J.D., C.P.A., Ch.F.C.

Teague Rotenstreich Stanaland Fox and Holt, P.L.L.C.

101 South Elm Street, Suite 350

Greensboro, North Carolina 27401

Telephone: 336-272-4810

Facsimile: 336-272-2448

(tbs@trslaw.com)

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Remaining Relevant In a World With No Estate Tax

A Survival Guide for the Estate Planning Professional

I. The Demise of the Estate Tax

A. Current Proposals and Current Environment

B. The Ethos of Estate Planners: The Characteristic Spirit Which

Animates a

Culture or Community

1. Our Ethos is Simple: We are Asset Preservation Specialists

with An Emphasis on Intergenerational Transfers.

2. The Estate Tax is Just One More Threat With Which We Must

Contend.

II. How to Remain Relevant

A. Apply Existing Solutions and Techniques to Different, Often Over-

looked Problems

1. Spend Time Exploring Client Concerns, Learn to Draw From the

Clients any Additional Concerns

2. Definitely Think Outside the Box. Plow New Ground With An

Old Mule

B. Become Even More Expert on How to Address Over-looked Threats:

Lawsuits, Divorce, Profligate Children, Substance Abuse Issues, Elder

Law Concerns and Income Taxation.

C. Become Expert in Areas Related to Your Core Focus: Learn More

About the Income Tax, Study Taxation of Life Insurance, Focus on

Basis Issues. Learn Required Minimum Distribution Requirements on

Individual Retirement Arrangements.

III. Examples of Remaining Relevant: Old Tools for New Jobs.

A. Family Limited Partnerships: How to Give it Away and Keep Control

1. Income Diversion

2. Tax Implications

3. Discounts

4. Cautionary Notes

5. Rescue Over Funded UTMAs

B. Section 529 Plan for Creditor Protection

1. North Carolina Guidelines

2. General Principles

C. Trusts for Asset Preservation Planning

1. Basic Protection Planning in a Variety of Settings

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a. “I Don’t Really Trust my Son-In-Law.” Planning for

Unstable Marriages.

b. My Daughter, the Doctor, Is Always Worried About

Lawsuits . . .”

Planning Against Predators.

c. “My Son Drinks a Little . . .” Planning for Substance

Abuse.

d. “If I Die, I Want my Wife to Remarry . . .” Planning for

Second Marriages.

2. Trusts For a Special Needs Person

a. “My Son Has Downs Syndrome. . .” Third-Party Special

Needs Trust

b. “My Wife’s Memory is Beginning to Slip. . .” Trusts For

Management and Control.

c. “If I Die, What Happens if my Husband Goes Into a

Nursing

Home. . .” By-Pass Trust Planning For Medicaid

d. “Should I Give Away my Assets Now. . .” Defective Trusts

and Double Defective Trusts.

D. Integrating Qualified Plan Assets with Trusts Planning

1. Required Minimum Distributions at Death.

a. Death Before Age 70 1/2;

i. Spouse as Beneficiary

ii. Non-Spouse Beneficiaries

(a) Designated Beneficiary

(b) No Designated Beneficiary

b. Death After Required Beginning Date

i. Spouse as Beneficiary

ii. Non-Spouse Beneficiaries

(a) Designated Beneficiary

(b) No Designated Beneficiary

2. Designated Beneficiary

a. General Rule

b. Trust As Designated Beneficiary

c. Perplexing Issues

3. The Conduit Trust

E. Pass Through Entities and Succession Planning

1. Subchapter S

a. Distribution of Appreciated Assets

b. The Case of the Wasted Basis

IV. CONCLUSION.

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Remaining Relevant in a World With No Estate Tax: A Survival Guide For

The Estate Planner

I. The Demise of the Estate Tax

A. Current Proposals and Current Environment

At the time of the drafting of this manuscript, the United States has recently

had a national election in which a new President was elected and in which control of

the Senate went to the same party currently in control of the House. We now have

a political party that has dedicated itself to the notion of total repeal of the Estate

Tax in control of the Legislative and Executive Branches of our federal government.

It is the rare Republican Politician that does not run on, and is not dedicated to the

repeal of the Estate Tax. It is anticipated that legislation will be introduced

proposing a complete and out-right repeal of the Estate Tax.

Regardless as to the outcome of any proposed legislation, the Estate Tax has

already achieved irrelevance for the vast majority of Americans. The Congressional

Budget Office calculates that the Estate Tax would only be a concern to the top 2%

of the top1% of estates in America. Another way to view this startling statistic is

that 99.8% of estates would not have an estate tax concern even in the current

environment. Thus, the Estate Tax has become much less of a threat to the

accumulated wealth of American’s intent on preserving as much of that wealth as

possible for the next generation.

B. The Ethos of Estate Planners:

Ethos is defined in many ways, but a common definition is that ethos

represents the characteristic spirit of a culture or a community. If we view our

colleagues in professions relating to Estate Planning, most would agree that the

ethos of the estate planning community is that we are Asset Preservation

Specialists with an emphasis of intergenerational transfers of wealth. Viewed from

this strategic perspective, one quickly realizes that the estate tax is just one more

threat with which Estate Planners must contend in carrying out their duty to

protect client’s assets from a variety of threats and to design intelligent methods to

transfer that wealth between the generations. Most would readily agree that the

estate tax is no more of a threat to a client’s wealth than would be the threat to

inherited wealth received by an heir with substance abuse problems. There are

many threat to a client’s wealth and the estate tax is simply one of those numerous

threats.

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II. How to Remain Relevant

A. Apply Existing Solutions and Techniques to Different, Often

Overlooked Problems.

1. Spend Time Exploring Client Concerns. Learn to Draw from

the Clients, Any Additional Concerns.

Imagine that the year is 2008 and the Estate Planner is sitting down with

new clients that have an estate significant enough that the Estate Tax should not

be ignored, but not significant enough to demand all of the planner’s attention.

This would be a fairly common situation for the vast majority of Estate Planners

over their careers. Realizing that client meetings to prepare and implement an

Estate Tax Sensitive Estate Plan would typically occur over three or four meetings.

During these three or four meetings, the Estate Planner is forced to spend a

disproportionate amount of time educating the clients on the application of the

Estate Tax, how it is calculated and how it is applied and the various tools and

techniques which can be used to reduce or eliminate the Estate Tax. In settings

such as this, and with the Estate Tax dominating the conversation, there was little

opportunity to discuss the client’s other concerns such as a child with substance

abuse issues, or a spend thrift child, or a child who is in a troubled marriage.

With the demise of the Estate Tax, the Planner is now free to sit and explore

with the client the client’s other concerns. The Estate Planner would be well served

to learn how to draw from the client the client’s concerns regarding the transfer of

their wealth to the next generation. The Estate Planner can now talk about the

client’s children, the spouses of the client’s children and the client’s grandchildren.

It would be the rare family that does not have a concern regarding one or more of

their children or grandchildren. Once we draw from the client those additional

concerns, we are then in a position to use the tools and techniques developed over a

lifetime of professional practice to solve the client’s additional concerns.

2. Definitely Think Outside the Box. Plow New Ground With An

Old Mule.

Although it is quaint and clichéd to reference “Thinking Outside the Box”

that is a particularly apt phrase in this context. One should always be aware and

be cognizant of the fact that a By-Pass Trust was nothing more than a spend thrift

trust designed to permit a surviving spouse to use assets but not to own those

assets. There are numerous situations when a client would wish to arrange her

affairs such that a family member could use assets without owning those assets. If

one owns the assets, then those assets can be lost to a myriad of issues affecting

that individual’s life. There are other ways to lose assets other than the Estate Tax.

Disgruntled former spouses, substance abusing children and injured third-parties

can all do an excellent job of reducing one’s net worth. So, in an environment with

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no Estate Tax, the Estate Planner is free to plow new ground with an old an

experienced mule and with tools that have been carefully crafted and hand-honed

over many decades.

B. Become Even More Expert on How to Address Over-Looked Threats:

Lawsuits, Divorce, Profligate Children, Substance Abuse Issues, Elder

Law

In a world with no Estate Tax, the Estate Planner would be well served to

learn not only how to draw from the client any concerns and fears, but also to be in

a position to use the tools and techniques we have developed to apply to these new

threats. This will require the Planner to know a little more about other related

areas. For example, an Estate Planner attempting to protect the client’s child’s

inherited assets from a bad marriage would be required to know a little bit about

Equitable Distribution and how it would generally be applied to inherited assets.

Similarly, the Estate Planner that has a passing familiarity with Elder Law would

now be well-served to learn the use of trusts to preserve client assets even if the

client experiences a nursing home event or another event requiring medical care

and expenses beyond any public assistance or the limits of any insurance policies.

C. Become Expert in Areas Related to Your Core Focus: Learn More

About the Income Tax, Study Taxation of Life Insurance, Focus on

Basis Issues. Learn Required Minimum Distribution Requirements on

Individual Retirement Arrangements.

In a world with no Estate Tax, the Estate Planner has more time to focus on

other tax related threats rather than simply the Estate Tax. For example, the

taxation of life insurance is poorly understood by most Estate Planners yet can have

a significant impact on preservation of wealth. The same concept applies to

preserving the ability to recognize income from an Individual Retirement

Arrangement over as a long period of time rather than being subjected to taxation

on an accelerated basis. Finally, many Estate Planners are well-grounded in tax

issues and should continue to expand on his or her knowledge on tax issues other

than the Estate Tax. Many Estate Planners do not really understand basis issues

and how basis issues can be applied to inherited assets or how basis issues can

affect the proper structuring of a Buy-Sell Agreement.

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III. Examples of Remaining Relevant: Old Tools for New Jobs.

A. Family Limited Partnerships:

1. Income Diversion

The Family Limited Partnership (FLP) is simply a limited partnership

established between members of the same family. In the typical setting the senior

generation family member will hold a general partnership interest in the limited

partnership with the children serving as limited partners. This arrangement is

tried and true and has been utilized for many years. The Family Limited

Partnership is generally used as an asset protection technique or as a technique

designed to reduce gift tax and, ultimately, estate tax. However, family limited

partnerships offer several income tax advantages as well.

What many senior generation family members find most attractive about the

family limited partnership is the ability to transfer a significant asset while still

retaining some element of control over the asst. The desire to retain control is

present in traditional gifting arrangements or in dispositions in a buy and sale

environment.

The primary income tax advantage of the Family Limited Partnership is the

diversion or shifting of income to lower bracket taxpayers and, perhaps, to make

palatable more sophisticated techniques such as intra-family installment sales.

2. TAX IMPLICATIONS

From an income tax perspective, family limited partnerships are taxed under

the general rules governing the taxation of partnerships. Generally, a family

limited partnership is a “flow through” entity in that it does not pay federal or state

income tax but rather, the income of the partnership is allocated to the partners. At

the risk of oversimplification income would be allocated to the partners under what

is sometimes referred to as the “per partner per day basis”. In the typical family

limited partnership environment there will rarely be a transfer of partnership

interests during any given year. Thus, in most cases, income will be allocated to the

partners on a prorated basis, based on each partner’s capital account compared to

all of the capital accounts of the partnership.

The primary focus of our discussion will be use of the family limited

partnership as an intra-family income shifting technique. The primary benefit

offered by the family limited partnership is income shifting or diversion of income to

lower bracket individuals. For a very simplified example, assume that Senior

Generation Family Member is receiving income of approximately $100,000.00 per

year and further assume that the income is not needed for current consumption. If

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the portfolio were transferred to a family limited partnership, the income would

flow to junior family members based on their ownership interests in the

partnership. Continuing the preceding example, if Senior Generation Family

Member retained a 10% ownership interest then 10% of the income of the portfolio

would be taxed to Senior Generation Family Member and 90% would be taxed to

other family members. Thus $90,000.00 worth of income has been shifted to Junior

Family Members who are in lower tax brackets, not subject to the alternative

minimum tax, not subject to the phase out of exemptions and deductions and any

other purposes for which income shifting is desired.

One should note that the family limited partnership can be combined with

other techniques such as intra-family installment sales or sales involving the use of

private annuities to leverage the income, gift and estate tax advantages to an even

greater extent.

The family limited partnership is the technique of choice for those involved in

agricultural enterprises such as family farms, timber concerns and ranchers. If a

sale of the underlying asset is contemplated the family limited partnership may

offer the opportunity to shift the recognition of that gain to junior family members

rather than to the senior family members. However, one should be aware of the

requirement that contributions of property subject to a built in gain will require

that gain to be allocated to the contributing partner if the property is sold within

seven years of its contribution to the partnership.

3. DISCOUNTS

The focus of the discounts provided by the family limited partnership is

generally an attempt to reduce estate tax or gift tax. However, discounts can also

provide tremendous income tax savings and, ultimately, income tax deferral. For

example, consider a senior family member who wishes to transfer a family business

to a junior family member and the senior family member still needs income. In a

traditional gifting environment once the asset has been gifted then all of the

benefits flowing from the asset accrue to the transferee and is no longer available to

the senior family member. This can often dissuade the senior family member from

entering into the transaction. If, instead, the property is placed in a family limited

partnership the limited partnership interest could legitimately be sold subsequent

to the formation of the partnership and such sale would be subject to all available

discounts. Discounts of 30% or more are routinely attributed to dispositions of

limited partnership interests. Thus, continuing the earlier example, if the limited

partnership units were sold for $700,000.00 rather than for the fair market value of

the underlying asset of $1,000,000.00 then $300,000.00 of gain has not been

recognized by the senior family member and will be deferred until the junior family

member ultimately disposes of the underlying asset. This is a non-traditional use of

a very traditional technique, which provides tremendous income tax savings.

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4. CAUTIONARY NOTES

There are very few techniques that offer all of the income gift and estate tax

advantages provided by the family limited partnership. It is absolutely the

technique of choice for those who wish to dispose of an asset while still retaining

some element of control. However, care should be taken in the formation and

operation of the family limited partnership. It has been the author’s experience

that very few family limited partnerships would pass muster with the Internal

Revenue Service if the partnerships were subject to a great deal of scrutiny. As has

been recently learned with the Strangi case and the related line of cases, it is the

operation of the family limited partnership, which may provide the greatest pitfall.

Not only must the technique be structured correctly but all formalities must be

maintained and a business purpose for the transaction must be present. There are

numerous business purposes related to the use of family limited partnerships and

the business purpose requirement should provide a low hurdle to be overcome.

However, the partnership must simply be operated in accordance with its terms, as

would any formal business relationship among non-related individuals. With this

cautionary note, and assuming that the partnership is operated correctly, the family

limited partnership provides a powerful tool for income tax planning as well as

more traditional use.

5. Rescue Over-Funded Uniform Transfers to Minors Act (UTMA)

Accounts

The family limited partnership also provides a mechanism to rescue Uniform

Transfers to Minors Act accounts that may have accumulated more assets than the

custodian is comfortable with turning over to a twenty-one year old. Specifically,

under North Carolina Uniform Transfers to Minors Act a custodial account ends

when the minor attains the age of twenty-one. Many parents are uncomfortable

with significant funds being turned over to a still immature individual.

The family limited partnership provides a solution to this quite common

problem. The technique would involve a formation of a family limited partnership

wherein the parent of the minor would be the general partner and the UTMA

account would be the limited partner. The typical general partner would retain 1%

as a general partner and the limited partners would have 99% of the partnership

units. The general partner would then convey 1% of the total value of the

partnership directly to the partnership in exchange for the general partnership

interest. The UTMA account would convey its assets to the family limited

partnership in exchange for which the custodial account would receive 99% of the

partnership units. When the minor attains age twenty-one, the custodian account

terminates and the minor would receive all that is in the custodial account. Of

course, at that point, all that would be in the custodial account is a 99% interest in

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a family limited partnership which will be exclusively controlled by the general

partner.

B. Section 529 Plan for Creditor Protection

1. North Carolina Guidelines

Internal Revenue Code Section 529 establishes the parameters of a special

type of savings account to be used, primarily, for college education planning. When

enacting Section 529 of the Internal Revenue Code Congress provided broad

parameters and deferred to the states to set many of their individual details.

While these types of accounts provide an excellent means of saving for college

education, they can also provide other benefits. For example, it is a general

proposition that if one gifts an asset yet still retains control over the asset then the

asset would be included in the estate. However, Section 529 provides an exception

to this and the gift to the 529 Plan would be outside of the estate of a donor even if

the donor acts as custodian of the Beneficiary’s Account.

In North Carolina, the maximum amount that can be contributed for any one

beneficiary is $450,000.00.

2. General Principles

While the tax benefits of the educational accounts are well known, many

individuals overlook the possibility of using these accounts for creditor protection

purposes. These accounts can provide a great deal of creditor protection. Of course,

we are assuming that the planning for these accounts and the funding these

accounts take place in an environment that would not give rise to a claim of a

fraudulent transfer. These accounts should not be used in an abusive manner

designed to defraud the creditors of the Participant. However, any individual

concerned with creditor issues would be well served to familiarize himself or herself

with the rules relating to the creditors rights to a Participant’s Section 529 Plan.

Specifically, these types of accounts are subject to Federal Bankruptcy Law and,

under certain circumstances, will be part of the bankruptcy estate. Generally,

contributions made within one year of the time that the Participant files a petition

in bankruptcy court will be considered a part of the bankruptcy estate and will be

subjected to the claims of the Participant’s creditors. Contributions made prior to

one year preceding the date of the bankruptcy filing but less than two years from

the date of the bankruptcy filing are not deemed to be part of the estate to the

extent that the contributions do not exceed $6,225.00. It is important to note that

the protections provided herein only apply to accounts that are established for the

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Participant’s child, step-child, grandchild, or step-grandchild. After two full years,

contributions to the account remain exempt from creditor’s claims.

Please note that if the Participant wishes to receive these funds back and

further assuming that the funds would not be used for Qualifying Higher Education

Expenses, then the earnings would be subject to ordinary income tax rates together

with a 10% penalty. However, one should keep in mind that the time value of

money is a truly amazing thing and that several years of tax deferral combined with

a reasonable rate of return would more than make up for the taxes to be paid later

and the penalty to be paid on such taxes.

C. Trust for Asset Preservation Planning

1. Basic Protection Planning in a variety of Settings

As set forth above estate planners are peculiarly well suited to apply their

skills and knowledge to planning environments where the Estate Tax is not the

primary issue. Trusts will continue to be an extremely important tool to be used in a

variety of settings. The following discussion is not intended to be comprehensive but

will set forth common problems identified by clients and how trusts can be utilized

to accomplish the client’s objectives.

a. “I don’t really trust my son-in-law…” Planning for unstable

marriages

A hypothetical conversation beginning with the preceding sentence is so

common as to be clichéd. If this client does not mention this in the initial estate

planning interview the planner who raises this issue may be surprised at the raw

emotion this would provoke. The Trust provides a perfect solution for addressing

this concern. While assets inherited from third parties during the marriage are

typically exempt from marital claims this is a protection that is difficult to preserve

and maintain. Clients frequently co-mingle inherited assets with other marital

assets and, consequently, erode the protections accorded inherited assets. The

equation is quite simple: If assets are inherited outright, there is a greater

likelihood that those assets could be lost if the marriage were dissolved. On the

other hand, if the assets are not directly inherited they will be much better

protected. The client should be made aware of this fact and encouraged to leave the

child’s share in a trust for the child’s benefit. Rather than receive the inheritance

outright, the inheritance could be received by way of the trust.

The design of this trust would be premised upon the objectives to be achieved.

Specifically, these trusts are really not intended to be an impediment to the child’s

access to the funds but, rather, seek to preserve the separate nature of these assets.

Thus, the trust should be designed to be as flexible as possible. The issue of

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paramount importance is the choice of Trustee. In this setting it would not be

uncommon to have the child act as his or her own Trustee. While this makes it more

likely that the child could erode the protections which the trust affords it does

provide the greatest amount of flexibility. If the client has more than one child

perhaps the children could, collectively, serve as the Board of Trustees for a trust

created for each child.

The trust could be designed to give the child all of the income produced by the

trust and the child could be given access to the principal as well based on the

discretion of the Trustees. Again, this trust is not intended to remove the inherited

assets from the estate of the child for estate tax purposes. The trust is simply

intended to protect the child’s inherited assets. Thus, giving the child the right to

invade the corpus could be included without concern over the estate tax

implications. Similarly, the child could be given a testamentary power of

appointment which could be either limited or general based on the decision made by

the parents.

b. “My daughter, the Doctor, is always worried about lawsuits…”

Planning Against Predators

In addition to a concern that inherited assets could be lost if a child suffers a

marital dissolution, another common concern is a child losing inherited assets to

some other type of creditor. It is trite but true none the less, to observe that we live

in a litigious society and the threat of lawsuits is ubiquitous and shared by many.

Again, the equation is simple: If the assets are inherited, outright, they are

vulnerable to predators. If the assets are inherited by way of a trust vehicle they

can enjoy a much greater degree of protection.

Here, the trust would be as flexible as possible since the objective is to protect

the assets not from the child but from the child’s creditors.

In this setting having the child serve as Trustee would be very important.

The trust should certainly incorporate any available spendthrift provisions

available under state law that protects assets from the reach of creditors. Further,

the child who is the beneficiary of the trust could be given the right to distributions

of income from the trust and further enjoy the right to invade principal limited to

an ascertainable standard.

In an effort to provide maximum flexibility for the child in his or her own

estate plan the child should be given, at a minimum, a special testamentary

power of appointment to be exercised in the Last Will and Testament of the child.

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c. “My son drinks a little…” Planning for Substance Abuse

At the risk of broaching a topic that is highly sensitive, it is certainly

appropriate for the planner to inquire as to any substance abuse problems faced by

the client’s children. If this problem is identified then a trust would provide a

perfect solution.

In this setting we are very much concerned about the child having

unrestricted access to the trust so having the child as sole Trustee would not be

appropriate. Perhaps the child could participate as a co-Trustee but the child’s

ability to act unilaterally should be circumscribed.

A trust for a child with substance abuse problems should probably be

structured as a discretionary trust with distributions to be made at the discretion of

the Trustee. Further, these trusts may very well last for the lifetime of the child so

a corporate Trustee would have to be discussed.

A special testamentary power of appointment would be included to permit the

child to incorporate these assets in the child’s own estate plan. Finally, spendthrift

provisions should be included to the greatest extent possible.

d. “If I die I want my Wife to Remarry but…” Planning for Second

Marriages

Another quite common concern and one with particularly bitter implications,

is a potential second marriage. This really is another species of protection against

predators although the predators could appear to be quite benign. If the client truly

wishes to protect assets from a potential second spouse of a surviving spouse then,

again, a marital trust would be a viable solution. This trust could be designed to

qualify for the marital deduction or not, depending on the level of concern with any

future Estate Tax. Thus, the trust could be designed as would a typical QTIP Trust

or a General Power of Appointment Trust on behalf of the surviving spouse.

In this setting involving the surviving spouse as a co-Trustee seems

warranted and provisions regarding distributions should be quite generous.

These trusts would typically not include a general testamentary power of

appointment but, rather, a special testamentary power of appointment exercisable

in favor of the couples issue would be more appropriate.

2. Trusts for a Special Needs Person

The planning issues referenced above typically involve protecting the child

from outside forces. Those who suffer physical and mental infirmities are

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particularly well served by having a potential inheritance protected in a trust

environment. The following situations, although not comprehensive, reflect common

concerns of those who have loved ones with special needs:

a. “My son has Down’s Syndrome…” Third Party Special Needs

Trust

The greatest fear of any parent with a special needs child is the continuing

care of the child after the death of the parent. Of course, while the parent is alive

the special needs child will be cared for. However, the mortality tables are

inexorable and it is reasonable to expect that the special needs child will outlive the

parent. Individuals with special needs may have a greater need for public

assistance which, in many cases, is only available to those without adequate

resources. In this setting an outright bequest to a special needs child in addition to

the obvious problem of the child’s lack of capacity, would deprive the child of access

to government benefits. It is important to note that if the child receives the

inheritance outright those funds will, in all probability, be doing nothing more than

deferring the child’s access to public assistance. The third party special needs trust

is a good solution to this problem.

Most of the needs-based state and federal programs providing assistance to

special needs individuals take into account assets that are owned by the special

needs person or assets that are required to be used for the care of the specials needs

person. The third party special needs trust would be designed in such a manner

that the funds would not be counted as a resource of the special needs person for

purposes of determining financial eligibility. This is typically accomplished by

carefully addressing the standard for distributions of trust assets. If the Trustee is

required to use the resources of the trust for the care of the special needs child then

those funds will deemed to be a resource of the special needs child. On the other

hand if the Trustee is given the discretion to use the funds for the child but not the

obligation to use the funds for the child, the trust assets would be protected. Thus,

these trusts are inherently discretionary spendthrift trusts wherein the amount to

be distributed to the child is at the absolute discretion of the Trustee who is under

no obligation to use the funds for the care of the child.

b. “My Wife’s memory is beginning to slip…” Trust for

Management and Control

Another common problem besetting the elderly is memory loss. Specifically,

perhaps one spouse remains perfectly competent and aware while the other spouse

suffers from the creeping hell of dementia. Again, a trust can address the proper

management of the assets upon the death of the competent spouse if the spouse

with memory loss survives. In this setting proper asset titling would be a

tremendous importance. The plan would require that as many of the assets as

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possible would be titled in the name of the competent spouse. The competent spouse

would then prepare an estate plan which creates a trust for the benefit of the

surviving spouse. Thus, upon the death of the competent spouse the spouse

suffering from memory loss would be able to live off the assets without having the

ability to mismanage those assets or lose those assets to an outside predator or

creditor.

In this setting the memory loss spouse would not be Trustee but, perhaps, we

would look to an institution or to adult children. The standard distribution for the

surviving spouse would be discretionary rather than mandatory. Similarly, the

surviving spouse would not be given any powers of appointment over the trust

property in recognition that competency is an issue.

However, upon implementation and assuming that the competent spouse dies

first, all of the combined assets of the family would be held for the benefit of the

surviving spouse and protected to the greatest extent possible.

c. “If I die, what happens if my Husband goes into a Nursing

Home…” By-pass Trust Planning for Medicaid

Generally speaking trusts established for the benefit of an individual needing

institutional care will disqualify the individual from programs offering public

assistance. The Medicaid program has a specific exception for Testamentary Trusts

established for the surviving spouse upon the death of the first spouse to die. In

practice this type of arrangement would look very similar to traditional Credit

Shelter Trust planning.

The plan would call for each spouse to establish a Will which creates a special

needs Trust for the benefit of the surviving spouse. The specific language of the

Medicaid program which protects this type of arrangement refers to a

“Testamentary Trust” which is generally defined as a trust created under a Will.

Although the distinction between a trust established under a Will and a Trust

established under a Revocable Living Trust seems to be arbitrary and non sensical,

prudence dictates that we honor the language of the law until such time as further

guidance is provided. Thus, the family would embrace a greater degree of probate

than would be typical.

The actual design of the trust would be very similar to the special needs trust

discussed above for a child with special needs. The Trustee typically would not be

the surviving spouse and the Trustee would have discretionary authority to

distribute assets to or for the benefit of the surviving spouse. The surviving spouse

would not be given a general testamentary power of appointment and a special

Testamentary Power of Appointment should be included only after careful

reflection.

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d. “Should I give away my Assets now…” Defective Trusts and

Double Defective Trusts

Estate planners traditionally have encouraged clients to consider inter-vivos

transfers of assets in an effort to avoid the Estate Tax. In a post-Estate Tax

environment clients may very well wish to make inter-vivos transfers not for the

purpose of avoiding the Estate Tax but for the purpose of protecting assets from the

claims of creditors or to qualify for public assistance.

The primary technical issue embraced by significant inter-vivos gifting

relates to the basis of the transferred assets. With the reinstatement of the full step

up in basis, death forgives capital gains. The mechanism by which capital gains are

forgiven at death is by increasing the basis of the inherited assets to the fair market

value of those assets at the time of death.

Unfortunately, assets that are the subject of an inter-vivos gift do not qualify

for the step-up in basis but, rather, are subject to a carryover basis wherein the

basis of the assets in the hands of the transferee will be determined by reference to

the basis of the assets in the hands of the transferor. All things being equal, (which

they rarely are) one is better off to inherit assets rather than to receive assets as a

gift.

However, there remain ways to give away the asset for some purposes yet

retain enough control over those assets that the transfer will be an incomplete gift

for other purposes.

If a trust is technically defective for estate tax purposes then the assets in the

trust would be included in the estate of the Grantor and would, therefore, enjoy a

step-up in basis. The task faced by the practitioner is to create a trust that is

defective for income and estate tax purposes yet would still remove those assets

from consideration in determining the Grantor’s eligibility for public assistance.

One must carefully craft the provisions to be inserted in the trust.

Further, a gift of an asset to a defective trust (a.k.a. an intentional grantor

trust) would require that any gain or loss recognized upon a subsequent disposition

of those assets would be taxed to the Grantor not to the beneficiaries. A client

contemplating the gift of a personal residence would be well served to consider

gifting the personal residence to a defective trust. If the home is subsequently sold

the client would have preserved the ability to exclude gain from the sale of a

personal residence. However, a gift of the personal residence to a defective trust

could be structured as a completed gift for gift tax purposes and would also be

viewed as a completed gift for determining the donor’s eligibility for public

assistance.

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The requirement that the Grantor continue to pay income tax on any income

earned by the defective trust will continue to erode the wealth of the Grantor while

enhancing the assets protected in the inter-vivos defective trust.

D. Integrating Qualified Plan Assets with Trusts Planning

In the continuing quest to remain relevant estate planners should become

ever more proficient in addressing specific types of assets in the estate plan. The

emphasis will no longer be on estate tax planning but on protecting individual

assets and being sensitive to the tax characteristics of those individual assets. In

this regard nothing will be more important than learning the intricacies of

distribution planning for qualified retirement plans and how those distribution

rules can be integrated with traditional estate planning techniques. This discussion

will, for convenience, reference pre-tax retirement benefits as “IRA’s” in a generic

sense although the discussion will be applicable to all types of pre-tax qualified

retirement plans. Before beginning a detailed discussion of integrating IRA benefits

with the estate plan a review of the basics is appropriate.

1. Required Minimum Distributions at Death

a. Death before age 70 ½

If an individual dies owning an IRA prior to April 1st of the year after the

owner turned 70 ½ years of age (the “Required Beginning Date”) the beneficiary will

be required to address Required Minimum Distributions. The amount and timing of

these distributions will depend on who receives the assets.

i. Spouse as Beneficiary

If the decedent has named his or her spouse as the primary beneficiary of the

IRA assets then the surviving spouse may rollover the inherited benefits to another

IRA and treat it as belonging to the surviving spouse. In effect, the inherited IRA

becomes the spouse’s IRA and all Required Minimum Distributions will be

calculated based on the surviving spouse’s attained age.

Of course, the rollover of a decedent’s IRA is an option available to the

surviving spouse but is not mandatory. The surviving spouse could certainly elect to

leave the IRA in the name of the decedent and begin required minimum

distributions based on the spouse’s life expectancy by December 31st of the year

after the decedent’s death, or, at the option of the spouse, at such time as the

decedent would have begun Required Minimum Distributions.

Finally, a surviving spouse could elect to be subject to the so called five year

rule which would require that all of the assets in the IRA be distributed by

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December 31st of the calendar year containing the fifth anniversary of the death of

the decedent.

ii. Non-Spouse Beneficiaries

If the beneficiary is not the surviving spouse then the Required Minimum

Distributions depend upon whether the beneficiary is a Designated Beneficiary or

not. As will be more fully set forth below, in the language of the law the term

“Designated Beneficiary” is a term of art and is very specifically defined. More

importantly, for our current discussion, a Designated Beneficiary has distinct

advantages over a non-designated beneficiary.

(a) Designated Beneficiary

If the beneficiary is a Designated Beneficiary the Designated Beneficiary has

two options. Specifically, the Designated Beneficiary may withdraw all of the funds

in the inherited IRA by December 31st of the calendar year which contains the fifth

anniversary of the decedent’s death. This is, not surprisingly, referred to as the “five

year rule”. Additionally, the Designated Beneficiary may elect to withdraw the

money over the life expectancy of the Designated Beneficiary, as determined by

reference to the published mortality table required to be used by the Internal

Revenue Service. If there are multiple Designated Beneficiaries then one must

determine whether or not the separate accounts rule will apply. Generally, if all of

the beneficiaries are Designated Beneficiaries and if the Designated Beneficiaries

establish separate accounts by December 31st of the year after the decedent’s death

then the separate accounts rule will apply. If the separate accounts rule applies

then each beneficiary will use his or her own life expectancy to calculate the

required minimum distributions. As a simplified example assume that Dad died

naming his three children as beneficiaries. Assuming each child establishes his or

her account by December 31st of the year after Dad’s death and further assuming

that the single account has been separated into separate accounts, then each child

may use his or her own life expectancy to calculate Required Minimum

Distributions.

(b) No Designated Beneficiary

If the decedent dies without a Designated Beneficiary prior to reaching the

age of 70 ½ then the decedent’s IRA will be subject to the five year rule.

b. Death after Required Beginning Date

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If an individual dies after age 70 ½ or, more technically, after Required

Minimum Distributions have begun, the Required Minimum Distributions will be

different. The differences are as follows:

i. Spouse as Beneficiary

If an individual dies after his required beginning date and if the decedent’s

spouse is the sole beneficiary then the spouse has several options. First, the spouse

may elect a spousal rollover which will result in the inherited IRA being treated as

if it were owned by the decedent’s spouse. If a spousal rollover is not elected then

the remaining assets will be withdrawn over the life expectancy of the spouse or the

decedent whichever is longer.The surviving spouses’ own situation will determine

when Required Minimum Distributions must begin and the percentage to be

withdrawn.

ii. Non-Spouse Beneficiaries

If the beneficiary is not the surviving spouse then the Required Minimum

Distributions depend upon whether the beneficiary is a Designated Beneficiary or

not. As will be more fully set forth below, in the language of the law the term

“Designated Beneficiary” is a term of art and is very specifically defined. More

importantly, for our current discussion, a Designated Beneficiary has distinct

advantages over a non-designated beneficiary.

(a) Designated Beneficiary

If an individual dies after the Required Beginning Date and if the beneficiary

is a Designated Beneficiary then distributions must begin to the Designated

Beneficiary by December 31st of the year after the death of the decedent with such

distributions to be based on the Designated Beneficiary’s own life expectancy. This

distribution pattern is what is commonly referred to as a “stretch IRA” and is one of

the most useful provisions relating to distributions from an inherited IRA.

(b) No Designated Beneficiary

If an individual dies after his or her Required Beginning Date and if he or she

does not have a Designated Beneficiary then distributions must be made over what

would have been the participant’s remaining life expectancy. This is calculated by

reference to the Single Life Table provided by the Internal Revenue Service and will

be based on the age the decedent had attained on his or her birthday in the year of

death. All future distributions will be based on this divisor reduced by one for each

year after the death of the decedent.

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2. Designated Beneficiary

Based on the preceding overview of the rules relating to Required Minimum

Distributions after death one must realize that it is very important to determine if

the decedent had a Designated Beneficiary. Simply designating a person or entity to

receive the plan benefits does not result in the decedent dying with a Designated

Beneficiary. The rules are much more complicated as will be more fully set forth

below.

a. General Rule

The term “Designated Beneficiary” is defined in Internal Revenue Code

Section 401 (a) (9) (E) and in the Regulations pursuant thereto. The Internal

Revenue Code states that a Designated Beneficiary “means any individual

designated as a beneficiary by the employee.” While this seems fairly straight

forward the Regulations address this definition in more detail. It helps to

understand what is meant by Designated Beneficiary as much from exclusion as

from an outright definition. For example, as a general rule only individuals can be

Designated Beneficiaries. Estates are not Designated Beneficiaries. Charitable

Organizations are not Designated Beneficiaries. Corporations are not Designated

Beneficiaries. Partnerships are not Designated Beneficiaries. Generally, trusts are

not Designated Beneficiaries. Again, generally, only human beings meet this rather

strict definition. Of course, this is what makes it so difficult for the estate planner to

integrate IRA assets with sophisticated estate plans since sophisticated estate plans

use a variety of entities, chiefly trusts, to accomplish the objectives of the decedent.

This can also be a problem if an individual designates multiple beneficiaries to

receive the assets. In this case all beneficiaries must be Designated Beneficiaries in

order for the payout rules relating to Designated Beneficiaries to be

applicable.Fortunately, this last consideration can be addressed, after death, by

removing non Designated Beneficiaries prior to what is referenced as the

“Beneficiary Finalization Date”. Under the Regulations the Beneficiary Finalization

Date is September 30th of the year after death. For example, if an individual dies

leaving one-half of her IRA assets to a church and one-half of the IRA assets to her

son then, assuming the church receives its bequest prior to September 30th of the

year after death, the decedent will be deemed to have died with a Designated

Beneficiary and so could use his own life expectancy to calculate Required Minimum

Distributions.

b. Trusts as Designated Beneficiary

Recognizing that qualifying as a Designated Beneficiary is crucially

important, one should consider whether a trust could possibly qualify as a

Designated Beneficiary. The Regulations, in Section 1.401(a)(9)-4 set forth four

rules applicable to trusts which, if met by a trust, will treat the individual

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beneficiaries of the trust as Designated Beneficiaries for purposes of calculating

Required Minimum Distributions. In addition to the four rules set forth under the

Treasury Regulations one must be aware of a fifth rule which is inherent in the

other rules. Thus, in addition to meeting the four rules required under the

Regulations one final hurdle must be cleared.

The four rules in the Regulations are as follows:

● The trust must be valid under the state in which the trust

is created.

● The trust must be irrevocable or will become irrevocable upon the

death of the owner.

● All beneficiaries of the trust must be identifiable from the trust

document.

● The Trustee must provide certain documentation relating to the

trust to the plan administrator.

The four rules set forth above do not appear to be overly burdensome. It is

the fifth rule, which is not specifically stated in the Regulations which is more

troublesome. Specifically, this fifth rule requires that all beneficiaries of the trust

must be Designated Beneficiaries. Thus, if an individual creates a trust for the

benefit of his child and further provides that upon the death of the child the

remaining benefits will pass to a charitable organization, the trust will not be

treated as a Designated Beneficiary and the life expectancy of the decedent’s child

would not be used as the measuring life. However, if the trust meets these five rules

then the trust will be disregarded and the Internal Revenue Service will look to the

beneficiaries of the trust to determine the Required Minimum Distributions.

c. Perplexing Issues

Assuming that a trust meets all five of the requirements set forth above one

must then inquire as to whose life expectancy will be the determinative life

expectancy for purposes of calculating Required Minimum Distributions. Generally,

and assuming the separate accounts rule does not apply, the measuring life must

mean the individual with the shortest life expectancy. Thus, if a trust is set up to

benefit the decedent’s two children one of whom is twenty-five and one of whom is

ten then the life expectancy of the twenty-five year old will control all Required

Minimum Distributions. This problem can be particularly perplexing when

reviewing a properly drawn trust which addresses all of the various contingencies

which the trust may confront. The IRS, in the Regulations, has decided that the

separate accounts rule does not apply to benefits paid to a single trust and that,

therefore, one must determine the oldest trust beneficiary for purposes of

calculating Required Minimum Distributions.

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When determining the oldest potential beneficiary one must determine not

only the primary beneficiaries of the trust but all individuals who could possibly

receive benefits from the trust. For example, consider the following trust language:

“Benefit my son until he reaches age 25 and if he dies prior to reaching age 25 the

benefit shall be paid to my mother.” In this example assuming that the decedent

passed away before his child reached the age of 25, it is clear that the oldest trust

beneficiary is not the decedent’s child but, rather, the decedent’s mother.

In an attempt to be helpful in this regard the Internal Revenue Service

distinguishes between those individuals who must be taken into account and those

individuals that can be disregarded. The Regulations use the phrase “mere

potential successors” to disregard certain beneficiaries from consideration in

determining Required Minimum Distributions. This rule is actually applied by the

Internal Revenue Service to two types of trusts. If a trust is required to distribute

all plan distributions to an individual trust beneficiary then the IRS will consider

the oldest trust beneficiary as the measuring life and all other beneficiaries will be

considered “mere potential successors”.

However if a trust does not require that all plan distributions be distributed

to an individual, the trust is referenced as an accumulation trust and the Internal

Revenue Service provides more scrutiny to determine whose lives can be counted.

Determining the measuring life for an accumulation trust is an extremely technical

and difficult issue. Unfortunately, the Internal Revenue Service has not been very

helpful in this regard either in its published Regulations or in published Rulings.

The examples provided in the Regulations are deficient in this regard and the

Rulings that have been published by the Internal Revenue Service can be somewhat

inconsistent. Please keep in mind that these Rulings are all Private Letter Rulings

and are not authoritative. However, the Rulings do indicate that contingent

beneficiaries, if identifiable at the time of decedent’s death will be taken into

account and more remote potential successors can be ignored. For example, in one

Private Letter Ruling an individual died leaving his IRA payable to a trust for the

benefit of his spouse for her lifetime and upon the death of the spouse the benefits

would be distributed to the decedent’s “lineal descendents”. The Internal Revenue

Service determined that, since those lineal descendants were living at the time of

the death of the decedent, we need go no further to determine who would take trust

property if there were no lineal descendants. However, consider the following

arrangement: “Benefit my spouse for life and upon the death of my spouse divide

the assets among my children then living holding each child’s share, in trust, until

the child reaches the age of 25.” In this example, if the decedent dies and the

children are under the age of 25 it appears that, since the benefits are not directly

vested, we must look to see who would take the assets if a child died prior to

reaching the age of 25.

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It is not uncommon for trusts to include an “Ultimate Beneficiary” clause

which addresses this contingency. The typical Ultimate Beneficiary clause may

direct that any share that would otherwise lapse will be paid to the decedent’s heirs

at law. A decedent’s heirs at law can include ancestors as well as descendants.

Thus, assuming the decedent has a ninety-year old uncle and further assuming that

there exists a set of circumstances under which the uncle could receive benefits then

the uncle’s life would be the measuring life for these purposes.

3. The Conduit Trust

The problem set forth above relating to the identification of all beneficiaries

of a trust are not applicable if the trust is a so called See-Through Trust .A See-

Through Trust is a trust in which the Trustee is obligated to distribute to the

beneficiary all distributions received from the IRA. This appears to be a rather

simple and straight forward approach which provides the practitioner and the client

with a safe harbor for purposes of determining the measuring life used to determine

Required Minimum Distributions. The individual to whom the benefits can be paid

will be considered as the only beneficiary of the trust and that beneficiary’s life will

be the measuring life. All other beneficiaries can be disregarded. In effect, the

beneficiary of the trust is treated as if he or she was named directly as the

Designated Beneficiary of the retirement assets. It would seem to be a fairly simple

trust design to accomplish this purpose. However, one should note that if the trust

established for the beneficiary is to last for the beneficiary’s entire life time and

further assuming that the individual lives to his or her normal mortality there will

be nothing in the trust at the time of the death of the beneficiary. This result would

not obtain if the spouse is the beneficiary of the trust since the spouse’s life

expectancy may be recalculated and the benefits will probably last beyond the life

time of the spouse. The benefits that this type of planning provides can be profound

when one considers the stretch out opportunities, creditor protection benefits and

tax free compounding which this arrangement can provide with a younger

beneficiary.

E. Pass through Entities and Succession Planning

An area of tax law with which tax professionals must grapple on a daily

basis, yet which still remains as mysterious as electricity to many, is the taxation of

distributions, liquidations, and buy sell proceeds from pass through entities such as

Subchapter S Corporations and Limited Liability Companies. It is estimated that

75% of small businesses in America are structured as either Subchapter S

Corporations or Limited Liability Companies. There are substantial differences

between the two with, arguably, the Subchapter S Corporation being subject to a

greater degree of misunderstanding. Before beginning a detailed analysis of these

issues an overview of Subchapter S taxation as it relates to distributions of

appreciated assets must be had.

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1. Subchapter S

a. Distribution of Appreciated Assets

It is important to note that an S-Corporation and C-Corporation have the

same treatment when it comes to distributions of appreciated assets. However, to

fully understand the tax implications of distributions of appreciated assets a

general understanding of distributions from Subchapter S Corporations should be

had.

In analyzing distributions from a Subchapter S Corporation a distinction

must be made between those corporations that have Accumulated Adjustments

Account (“AAA”) and those that do not.

A corporation that has AAA has previously been taxed as a Subchapter C-

Corporation and, at some point in its career, the corporation has elected to be taxed

under Subchapter S. A corporation that was initially formed as a Subchapter S

Corporation will not have AAA.

An S-Corp with AAA that distributes cash to its owners will have the

following tax implications. First, the distribution to the shareholder will not result

in the recognition of income by the shareholder until such time as the distribution

exceeds the amount of available AAA. Once the AAA account has been exhausted

the distribution to the shareholder will result in ordinary income dividend

treatment to the extent that the corporation has Earnings and Profits from its time

as a corporation. Once all of the Earnings and Profits have been distributed the

distribution to the shareholder by the Subchapter S Corporation will reduce the

shareholder’s basis in the Corporation until it reaches zero. At that time any further

distributions will be characterized as a capital gain transaction by the shareholder.

An S-Corp which has no AAA will be taxed exactly as set forth above except

that there will be no distribution of Earnings and Profits from prior years. Thus,

distributions from an S-Corporation without AAA will reduce the shareholders basis

in her stock until such time as the basis becomes zero. Any additional distributions

will then be treated as a capital gain transaction.

With the preceding basics firmly in mind consider the effect of an S-

Corporation which distributes an appreciated asset to its shareholders. In this

situation the taxation will be different than as set forth above simply because the

corporate entity will be forced to recognize gain based on the distribution of the

appreciated asset. Again, from the perspective of the corporation, there is no

difference between a Subchapter S Corporation which distributes appreciated assets

and a Subchapter C Corporation which distributes appreciated assets. Under the

provisions of Internal Revenue Code Section 311 a corporation which distributes an

25

appreciated asset is required to recognize gain at the corporate level the same as if

the asset were sold to a third party.

However, of course, the primary difference between Subchapter S

Corporations and Subchapter C Corporations is not in the recognition of the gain

but, rather, who actually bears the burden of the tax liability. A Subchapter C

Corporation which distributes an appreciated asset must pay capital gains tax at

the corporate level.

A Subchapter S Corporation which distributes appreciated assets will

recognize gain at the corporate level but, under the provisions of Sections 1366 and

1371 the gain will be allocated to the shareholders on a per shareholder per day

basis. Further, under Section 1367 (a) (1) the recognition of gain by the shareholder

increases the basis of the shareholder’s shares. Thus, even though gain will be

recognized at the shareholder level the shareholder will have a higher basis in his

or her stock which will have the effect of reducing the recognition of any future

gains. All of the above results can provide a wonderful opportunity to distribute

appreciated assets of a Subchapter S Corporation with no payment of taxes if the

distribution of appreciated assets is part of a distribution in complete liquidation

upon the death of a shareholder. To illustrate this please consider the following set

of facts:

Assume that a sole shareholder of a Subchapter S Corporation dies.

Further assume that the corporation has one asset: a parcel of real estate

with a fair market value of $5,000,000 and a basis of zero. (These facts are, of

course, greatly over simplified). Further assume that the shareholder’s basis

in her Subchapter S stock prior to her death was zero.

If the estate of the deceased shareholder elects to liquidate the

Subchapter S Corporation such that the appreciated asset will be distributed

in complete redemption and liquidation the following tax effects will obtain:

1. The corporation will recognize a gain upon the distribution of the

appreciated asset in the amount of $5,000,000 (Internal Revenue Code

Section 336).

2. The gain recognized by the corporation will increase the shareholder’s

basis in her stock (Internal Revenue Code Section 1367 (a) (1)).

3. Upon the death of the Subchapter S shareholder the basis in her

Subchapter S stock was increased to $5,000,000. (Internal Revenue Code

Section 1014). Assuming that the value of the company was $5,000,000 at the

time of death.

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Thus, upon the distribution of the appreciated asset the S-Corporation’s

owner’s estate would have an “outside basis” of $5,000,000 and an “inside basis”

from the recognition of capital gain in the amount of $5,000,000. Further, the

estate’s basis will be reduced by $5,000,000 because of the actual distribution to it

which, as a practical matter, means that, the estate has not recognized any gain

or loss. The estate has a basis in the Subchapter S shares of $5,000,000. The

corporation is then liquidated and dissolved which is a capital gains transaction to

the shareholder (Internal Revenue Code Section 331). The estate has given up its

shares with a basis of $5,000,000 in exchange for nothing so the estate

recognizes a loss of $5,000,000. However, keep in mind that the distribution of the

appreciated asset by the corporation is reflected on the shareholder’s Schedule D as

a capital gain of $5,000,000. The loss recognized upon dissolution of five million

dollars off-sets the gain recognized upon distribution of the appreciated asset

of $5,000,000 for a net capital gain of zero.

The end result is that, the S Corporation has been dissolved and the gain

trapped inside the appreciated asset has been distributed on a tax free basis to

the shareholder. The shareholder now has a basis of $5,000,000 in the underlying

asset which will limit any recognition of gain upon disposition of the asset

received and also provides a much higher starting point for the calculation of future

depreciation deductions.

The outcome set forth above is exactly what one may expect on the

dissolution of an S-Corporation upon the death of its shareholder. Of course, the

primary factor resulting in the non-recognition of gain to the shareholder is the fact

that the shareholder’s shares in her corporation were increased to fair market value

upon death under Section 1014. In the above situation if there were another

shareholder who had not died that individual would have a different outcome

entirely.

To fully understand the taxation of appreciated assets assume the exact same

set of facts as above except there are now two shareholders neither of whom have

any basis in the shares. Further, assume that, upon the death of Shareholder A the

decision is made to dissolve the corporation.

We have already discussed the tax implications to the estate of Shareholder

A. However, let us examine the transaction from the perspective of Shareholder B.

Of course, all of the numbers we previously used will be reduced by one-half in

recognition that one-half of these shares are owned by a surviving shareholder.

First, the corporation’s recognition of gain will be allocated to the

shareholders on a per shareholder per day basis. Thus, Shareholder B will recognize

gain of $2,500,000. Further, upon recognition of this gain, Shareholder B’s basis in

his shares will increase to $2,500,000 under the provisions of Section 1367 (a).

27

Upon liquidation no further gain or loss is recognized. However, again, B has

recognized gain of $2,500,000 reflecting the corporate gain upon distribution. B’s

basis in the real estate is now $2,500,000.

It is also important to note that, under Section 334, the basis of the real

estate in the hands of both Shareholders is its fair market value of $5,000,000 or

$2,500,000 for the estate of Shareholder A and $2,500,000 for Shareholder B. If the

real estate that was distributed was sold by the two Shareholders shortly after the

transaction set forth above for $5,000,000, Shareholder A would recognize no

further gain nor loss nor would Shareholder B.

b. The Case of The Wasted Basis

Applying the basic rules set forth above in the context of a buy-sell agreement

can have some very interesting outcomes. Perhaps the most interesting outcome in

working with insured buy-sell agreements for Subchapter S corporations relates to

basis issues.

Of course, as previously discussed, accounting income for a Subchapter S

corporation always increases the basis of the shareholder’s shares in the S-

Corporation. This concept applies to taxable income as well as accounting income.

For example, if a Subchapter-S corporation receives death proceeds from a key

person insurance policy in the amount of $100,000 the shareholders of the S-

Corporation will increase their basis in their stock by $100,000.

This concept, when combined with the step-up in basis provisions of I.R.C.

1014 can have some very interesting results in an S-Corporation entity purchase.

This result is sometimes referred to as “the case of the wasted basis”.

To illustrate the above please consider the following set of facts:

Assume that AB, Inc., is a Subchapter-S corporation which is equally

owned by two shareholders: Shareholder A and Shareholder B. Further

assume that Shareholder A and B have zero basis in their S-Corporation

stock.

Assume that AB, Inc., Shareholder A and Shareholder B have entered

into a stock redemption agreement which is funded with a life insurance

policy on Shareholder A owned by the corporation in the amount of $500,000

and a life insurance policy on the life of Shareholder B owned by the

corporation with a face value of $500,000.

Finally, assume that AB, Inc. has a total value of $1,000,000.

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Assume that Shareholder A dies on June 30th, 2011. Based on the

preceding set of facts and assuming that the redemption agreement is

consummated, the following tax outcome would obtain: First, upon the death

of Shareholder A and in recognition that the total value of the corporation is

$1,000,000, Shareholder A’s estate has a basis in the shares of $750,000. This

result flows from the fact that Shareholder A’s estate is entitled to a step-up

in basis to the fair market value of the shares at the date of death of the

shareholder. Again, we are assuming that the total value of the corporation is

$1,000,000 such that Shareholder A ‘s value would be $500,000 which

increases the basis of Shareholder’s A’s shares at death.

In addition to the step-up in basis, the receipt of insurance proceeds

upon A’s death in the amount of $500,000 will result in an increase of

shareholder B’s basis in her shares to $250,000 and will also result in an

increase in the basis of Shareholder A’s shares in the amount of $250,000.

Thus, the basis of the shares of AB, Inc., in the hands of Shareholder A’s

estate, is $750,000.

Shareholder A’s estate is then obligated to have its shares redeemed by

the corporation for a redemption price of $500,000. The estate of Shareholder

A has “sold” its shares for $500,000 at a time when its basis in the shares is

$750,000. This is a capital loss and, unless Shareholder A’s estate has other

capital gains this capital loss will totally be wasted.

From the perspective of Shareholder B the basis is also wasted.

Specifically, recall that the corporation recognized income for accounting

purposes, but not for tax purposes upon the receipt of $500,000 of life

insurance proceeds. The life insurance proceeds increased Shareholder A’s

basis by $250,000 and also increased Shareholder B’s basis by $250,000.

Thus, after the transactions contemplated above have been completed

Shareholder B owns one hundred percent of a company worth $1,000,000 in

which she has a basis of $250,000. If Shareholder B sells all of her shares for

$1,000,000 to an outside party she will recognize gain of $750,000.

Please note that this result would be fundamentally different if this

were a traditional cross purchase. To confirm this consider the above

exact same set of facts except that the life insurance is not owned by the

corporation and that the buy-sell agreement is structured as a cross

purchase.

With these changed set of facts, at Shareholder A’s death Shareholder

B receives $500,000 worth of life insurance.

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As a result of the death of Shareholder A the estate of Shareholder A

has a basis in the shares of $500,000. These shares are then purchased by

Shareholder B for $500,000. The estate of Shareholder A recognizes no gain

and no loss and there is no wasted basis. Shareholder B, having just paid

$500,000 for the shares owned by Shareholder A will now have a basis in her

shares of $500,000.

If Shareholder B then sells her shares to an outside third party for

$1,000,000 her gain is $500,000 instead of $750,000, as previously set forth.

Fortunately, a solution does exist to address the case of the wasted basis. The

solution is for the Subchapter-S corporation to elect a “short year” to avoid

application of the allocation of income to the shareholders on a per share per day

basis.

As set forth above an S-corporation’s items of income, expense, loss and

deduction are allocated to the shareholders on a per shareholder per day basis.

However, Internal Revenue Code Section 1377 (a) (2) permits an S corporation and

its shareholders to elect out of this per shareholder per day “allocation”. If this

election were made and assuming that the life insurance proceeds were received by

the corporation after the death of the shareholder and after the redemption of the

shareholder’s shares, the life insurance will be deemed to have been received in the

following tax year. If the life insurance is received in the following tax year all of the

increase in basis attributed to the life insurance proceeds will be allocated to

surviving shareholder B.

Let us review this interesting outcome under the facts set forth above.

Again, continuing the preceding example, Shareholders A and B own a

Subchapter-S corporation: AB, Inc.. Shareholder A’s basis is zero and Shareholder

B’s basis is zero. AB, Inc. is worth$1,000,000 and the parties have established a

redemption agreement which is funded with a life insurance policy on the life of

each shareholder in the amount $500,000. Assume that shareholder A dies on

June 30th. Further assume that Shareholder A’s shares are redeemed by AB, Inc.,

prior to the receipt of any life insurance proceeds. Further assume that the

corporation makes a short year election.

In this scenario the estate of Shareholder A has a basis in the inherited

shares of $500,000 which represents the fair market value of the shares owned by

Shareholder A at the time of the death of Shareholder A. These shares are then

purchased by the corporation in exchange for a promissory note with a face amount

of $500,000. Based on these fats, the estate of Shareholder A sells its shares with no

gain or loss.

30

After the redemption has been consummated the corporation, which now has

only one shareholder, receives death benefits in the amount of $500,000 on the life

of Shareholder A. Since Shareholder A’s estate is no longer a shareholder all of the

life insurance proceeds will increase Shareholder B’s basis in her shares by

$500,000.

If Shareholder B then sells her shares for one million dollars she has a basis

of $500,000 and recognizes a capital gain of $500,000. The estate of Shareholder A

recognized no capital gain and Shareholder B’s basis is increased by all of the life

insurance proceeds so received. This eliminates the so called “wasted basis” and the

result is that an S-corporation redemption properly structured with a “closing of the

books” election will start to look very much like a cross purchase agreement from a

tax perspective and from the perspective of the surviving shareholder.

IV. Conclusion

Hopefully, this manuscript has confirmed the wisdom contained in the old

adage “the more things change, the more they stay the same.” In the context of

estate planning we know that laws can change, but the conditions afflicting

humanity do not seem to change. There will always be a need for individuals to

preserve and protect the assets they have accumulated and to intelligently transfer

those assets to future generations. Estate planners find themselves free of the

limitations imposed by the federal estate tax laws of the last century and are able to

much more efficiently and effectively address other client concerns. To remain

relevant simply means that the professional advisor is to remain grounded in the

fundamental premise that we are first and foremost asset protection planners with

all other aspects of our professional lives merely an expression of that overarching

theme.