Developments from Heckerling Institute, Pt. II

I now post Part II of Paul T. Fabiano's observations from the annual Heckerling Institute held January 14-18, 2008, in Orlando, Florida. Paul works with Cornerstone Advisors in Allentown, PA.

For the first of three installments of his observations, see: PA EE&F Law Blog posting, "Developments from Heckerling Institute, Pt. I" (02/11/08). I thank him for this additional contribution. The final segment, Part III, will appear next week.

2008 Heckerling Highlights, Part II

Paul T. Fabiano, JD, LLM

Cornerstone Advisors

FLP Valuation Issues

1. Gift on Formation: To avoid making a gift on formation of a family limited partnership, the transferor should first fund the partnership and properly credit capital accounts. Thereafter, preferably the next tax year, he or she can transfer partnership interests. Although not reflecting reality, planning must avoid an argument that the subsequent transfer was contemplated at the time of the capital contribution.[1] This applies equally after formation to indirect gifts resulting from additional contributions. Traditionally, indirect transfers do not receive a discount because they are valued, instead, based on the amount given up by the transferor.

2. Bad Facts: The best advice for planning with FLPs is to avoid bad facts on formation and operation. In essence, you do not want your client to be the one that gets caught by the bear. This is still where the Service has found its traction on estate inclusion under various arguments.

• Disproportionate Distributions. The partnership should not make disproportionate distributions to the senior family member.[2] Even proportionate distributions that cover the senior family member’s expenses are risky.

• Power of Attorney. The partnership should not be set up by an agent acting under a power of attorney for the senior family member.[3]

• Payment of Taxes. An estate’s post-death use of partnership funds to pay estate taxes demonstrates that the decedent did not retain sufficient liquid interests during life.[4] This rationale applies equally to a redemption of the decedent’s interests. Consider using life insurance instead or borrowing from the partnership under commercially reasonable terms, if needed.

3. Control of General Partner's Interest: Although there is little authority specifically isolating the retention of general partner interests, it is best if the senior family members hold no control at death given the retained control arguments. Even better, they should relinquish any controlling interest at least three years before death to avoid an inclusion look-back under IRC §2035. If senior family members must serve as general partners, check the partnership boilerplate to remove “sole and absolute” authority and overly protective exculpatory clauses.

4. Attorney-Client Privilege: Legitimate non-tax business purposes can help prove a bona fide sale for adequate consideration in the creation of FLPs, avoiding some inclusion arguments.[5] Showing these, however, would likely involve testimony by the drafting attorney and waiver of the attorney-client privilege. In other words, client files should focus on the non-tax reasons rather than discounting opportunities. Keep this in mind in creating FLPs.

5. Risk of Marital Underfunding: If the undiscounted value of an FLP is included in the senior family member’s estate, there is a significant risk of causing estate tax on the first death when a marital deduction is involved. Any partnership interests left to a marital trust for the benefit of the surviving spouse probably won’t get the same undiscounted treatment, causing a disconnect between the inclusion value and the marital deduction. If involved in a risky FLP, be sure to recognize this potential problem.

S Corporations

6. 100 Shareholder Rule: The rules governing the allowable number of shareholders in an "S" corporation expand well beyond the 100 indicated.[6] There is a very broad definition for “all members of a family” that greatly reduces the number of shareholders actually counted, particularly in a family owned business. All members of a family include lineal descendants of a common ancestor (up to six generations) and the current and former spouses of the lineal descendants or the common ancestor.[7]

7. Non-Approved Shareholders: If the owners of a business venture wish to elect "S" corporation status with non-approved shareholders (e.g., nonresident aliens), a structure using a subsidiary LLC may solve the problem. In this structure, an "S" corporation would proportionately own an LLC that holds the assets of the business.

• The non-approved persons would own a proportionate interest in the LLC. For example, the non-approved shareholders can hold their 10 percent directly of the LLC, and the "S" corporation (owned by the approved shareholders) would hold 90 percent of the LLC.

• Be careful to consider any problems when a non-approved person (e.g., nonresident alien) is the spouse of an "S" corporation shareholder and resides in a community property state. The non-approved spouse could have an interest in shares that were acquired by the shareholder as compensation due to community property status.

8. Single Class of Stock: To meet the single class of stock requirement, all shares must have equal rights to distributions and liquidation proceeds.[8]

• Disproportionate Distributions. Despite the single class requirements, shareholders often take disproportionate distributions. In these situations, they should follow with equalizing distributions for the year.

• Buy-Sell Installments. When a corporation redeems a shareholder’s stock, the buy-sell agreement often allows installment payments. The installment terms should meet a debt safe-harbor to avoided being deemed an equity interest.[10]

• Split-Dollar Arrangements. To avoid a second class of stock when a corporation enters a split-dollar arrangement with a shareholder, the employee should reimburse the corporation for the economic benefit.[11] For arrangements entered after September 17, 2003, this would cause adverse income tax consequences. In that case, be sure the corporation’s obligation to pay is not binding (give it a right to terminate).[12] The second class of stock rules only take into account binding corporate agreements.

Business Succession Planning

There was a good discussion of the considerations, players involved, options and legal implications of business succession planning. In general, the following are keys to good planning:

• Keep outsiders out of the business, including non-active children.
• Give up on the idea of equalization, as it cannot be practically achieved.
  
• Use life insurance to its advantage to solve planning challenges.
  
• Use trusts liberally to protect the business from creditors and spouses, and to foster, design, and implement the succession plan.

9. QTIP Holding Stock: When a QTIP trust holds closely-held stock, there is a chance it will not be income-producing unless there are regular dividends. When combined with a restrictive buy-sell agreement, there is a risk that the surviving spouse’s right to convert unproductive property will be illusory, and the estate will lose the marital deduction. A suggested resolution is to give the trustee of the QTIP the additional power, in addition to distributing income, to distribute principal to the surviving spouse to the extent necessary to obtain the marital deduction.

10. Fiduciary Duty in Holding Stock: If the intent is for a trust to own closely-held stock or interests, the trustee should be alleviated of liability concerns for retaining it. Be sure to specify that trustee can retain the stock in contravention of all trustee’s duties to diversify (per the Prudent Investors Act), and trustee is indemnified and held harmless. This should include specific language regarding the ability to retain the stock during periods of a loss in value.[13]

11. Estate Tax Value Stipulation: In addition to the main valuation mechanism under a buy-sell agreement, some use the estate tax value as finally determined as a floor price for transfers at a shareholder’s death. The IRS could view this as evidence that the decedent did not think the value used otherwise would meet the requirements for fixing the estate tax value under IRC §2703. If this is a strong concern, a better alternative may be to simply provide for an appraisal price for the purchase.

Deferred Compensation

This session covered the recent changes to IRC §409A and taxation of deferred compensation arrangements. This includes plan mechanics and the expansion of the constructive receipt doctrine, including the prohibition now of a haircut provision to accelerate distributions and employer health triggers.

12. Vesting and Funding: It is important to recognize that as long as a plan participant is not vested in the deferral or the plan is not funded, the employee does not recognize income. Unvested means the employee’s right to receive future payments is not transferable and is subject to a substantial risk of forfeiture. Unfunded means the deferred compensation is only an unsecured promise of employer to pay employee in the future (employee would be in line with other general unsecured creditors).

13. Deferrals for Senior Family Members: A deferred compensation plan may be used to ensure continued salary to the senior family members after they transfer ownership. If the payments are to be respected as salary for purposes of the plan, it must be compensating them for earlier services to the company. Be careful, however, to avoid establishing that the owners were underpaid in prior years because that could trigger unpaid payroll tax obligations if successfully challenged.

Art Collectibles

There are a number of difficult tax considerations for active art collectors. Namely, it is not easy to obtain dealer status and therefore acquire the business characteristics necessary to take into account related expenses, losses and tax-free exchanges (for income tax purposes). The charitable deduction benefits were also significantly impacted by the Pension Protection Act of 2006.

14. Fractional Interest Gifts: After August 17, 2006, it is more difficult to make fractional interest gifts of art or collectibles to charities for income tax deduction purposes. The remaining interest must be transferred within 10 years and the charity must have a substantial physical possession during the donor’s interest period.[14] Donors no longer get the benefit of the increase in value when later gifting the remaining interest. Instead, the income tax deduction is limited to the proportional value of the donated items based on the date of the initial gift.[15]

• Split-Purchase Alternative. A good alternative to avoid the deduction limitation and 10-year requirements is to enter a split-purchase arrangement with the charity when acquiring an item.

• Technical Correction. A 2007 technical correction removed similar estate and gift tax deduction limitations, in order to prevent a mismatch with estate tax values at death.[16] However, fractional gifts must still be completed within 10 years.

15. Fractional Interest Discount: A fractional interest discount for gift tax or estate tax purposes appears to be a losing argument. Unlike other fractionally held property (e.g., real estate) co-owners in the art world are not likely to litigate and make the co-ownership difficult, as this is known in the art world to taint the item. A nominal discount of 5 percent is more likely.[17]

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[1] See Senda, T.C. Memo 2004-160 (July 12, 2004).

[2] Estate of Harper v. Comm’r, 83 T.C.M. (CCH) 1641 (2002).

[3] Erikson v. Comm’r, T.C. Memo 2007-107 (April 30, 2007).

[4] Rector v. Comm’r, T.C. Memo 2007-367(12/13/07).

[5] See Cohen v. Comm’r, 79 T.C. 1015 (1982) (which dealt with decedent’s control over a business trust).

[6] The Americans Jobs Creation Act of 2004.

[7] IRC §1361(c)(1)(B).

[8] Treas. Reg. §1.1361-1(1)(1).

[9] See, e.g., PLRs 200730009, 200524020 and 9519048.

[10] Treas. Reg. §1.1361-1(1)(4)(ii).

[11] PLR 9709027.

[12] This post Final Regulations consideration was not discussed at the Institute.

[13] See Fifth Third Bank v. Firstar Bank, No. C-050518, 2006 WL 2520329 (Ohio App., 1st Dist., Sept 1, 2006).

[14] IRC §170(o)(3)(A)(i).

[15] IRC §2055(g), IRC §2522(e).

[16] Technical Corrections Act 2007, Section 3(d).

[17] Robert G. Stone v. United States, 2007 U.S. Dist. LEXIS 58611 (N.D. Cal., August 10, 2007).

You may contact Paul at Cornerstone Advisors, 1802 Hamilton Street, Allentown, PA 18104 (Ofc: 610-437-1375; Fax: 610-437-4575; Email: pfabiano@cornerstone-companies.com).

Update: 02/25/08:

For Part III of Paul's observations from the Heckerling Institute, see: PA EE&F Law Blog posting "Developments from Heckerling Institute, Pt. III" (02/25/08).