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- Written by: Martin M. Shenkman, CPA, MBA, PFS, AEP, JD
With an aging population, higher income tax rates and more clients trying to live at home than in facilities, the medical expense deduction for home improvements could be increasingly important to clients in coming years. This may be so in spite of the high hurdle for medical expense deductions.
Increase in Number of Elderly Clients
The number of Americans over age 65 is estimated to increase to 71.5 million by 2030. In the year 2000, those over age 65 constituted 12.4% of the population. By the year 2030 it is estimated that those over age 65 will constitute 19% of the population. Americans 85 and older are the fastest growing demographic group. The U.S. Census Bureau projects that the population age 85 and over could grow from 5.5 million in 2010 to 19 million by 2050.
Increase in Number of Elderly that are Disabled
As clients age, and live longer, the incidence and duration of disabilities and health challenges will grow. So the statistics in the preceding paragraph about aging, understate the magnitude of change practitioners will experience in advising clients.
“Of critical importance are the number and proportion of our elderly population that will be disabled...the number of disabled persons at all levels of disability would grow rapidly between 1986 and 2040…the number of those severely or moderately disabled would more than triple during this period...Moreover, there is the possibility of a combination of high life expectancy with increased disability ratios. These assumptions result in a massive increase in the projected number of moderately or severely disabled elderly persons by 2040. The number would grow from about 5.1 million in 1986 to 22.6 million in 2040, or nearly 350 percent; the elderly population overall would grow by only 175 percent.”1
Clearly planning for the challenges of aging and disability will be an increasingly important component of most practices.
It is not Only Elderly Who Face Disabilities
37% of those who are disabled are 64 years of age and younger (3.7 million). 2
The lifetime probability of becoming disabled in at least two activities of daily living or of being cognitively impaired is 68% for people age 65 and older. 3
Most Disabled Clients Live at Home
Most people—nearly 79%—who need long-term care live at home or in community settings, not in institutions. Agency for Healthcare Research and Quality. Long-term care users range in age and most do not live in nursing homes: Research alert. Rockville: Author, 2000, cited at https://www.caregiver.org/selected-long-term-care-statistics.
New Practice Opportunities
The aging of the population will present many new practice opportunities. One example will be advising clients to plan to maximize the deduction for the costs incurred on making their homes accessible.
Overview of the Home Improvement Medical Expense Deduction
Home improvements may qualify as a medical expense deduction. Your client may be able to deduct the cost of special equipment and home improvements if the main purpose is his or her medical care. These can include: adding an accessible entrance ramp, installing a lift, widening doorways, building handrails, modifying cabinets, etc.
No deduction is permitted if the expense was for personal motives, such as aesthetic reasons. The deduction is also limited if the improvements increase the value of the home, Revenue Ruling 87-106, 1987-2 CB 67. Since this Ruling is one of the few authoritative sources about this deduction, it is explored in detail below.
These general guidelines, however, leave wide open a myriad of practical issues practitioners will have to address. The detailed discussion following will narrow these issues somewhat. Unfortunately, the lack of more detailed guidance will still leave much to the practitioner’s judgment.
Authorities
Some of the authorities on this specific planning matter include: a regulation, one Revenue Ruling, and a few cases. Each is explored below with comments and planning suggestions.
Treasury Regulation Section 1.213-1(e)(1)(iii)
Section 1.213-1(e)(1)(iii) of the regulations provides, in part:
“Capital expenditures are generally not deductible for Federal income tax purposes. See section 263 and the regulations thereunder. However, an expenditure which otherwise qualifies as a medical expense under section 213 shall not be disqualified merely because it is a capital expenditure. For purposes of section 213 and this paragraph, a capital expenditure made by the taxpayer may qualify as a medical expense, if it has as its primary purpose the medical care (as defined in subdivisions (i) and (ii) of this subparagraph) of the taxpayer, his spouse, or his dependent. Thus, a capital expenditure which is related only to the sick person and is not related to permanent improvement or betterment of property, if it otherwise qualifies as an expenditure for medical care, shall be deductible; for example, an expenditure for eye glasses, a seeing eye dog, artificial teeth and limbs, a wheel chair, crutches, an inclinator or an air conditioner which is detachable from the property and purchased only for the use of a sick person, etc. Moreover, a capital expenditure for permanent improvement or betterment of property which would not ordinarily be for the purpose of medical care (within the meaning of this paragraph) may, nevertheless, qualify as a medical expense to the extent that the expenditure exceeds the increase in the value of the related property, if the particular expenditure is related directly to medical care. Such a situation could arise, for example, where a taxpayer is advised by a physician to install an elevator in his residence so that the taxpayer's wife who is afflicted with heart disease will not be required to climb stairs. If the cost of installing the elevator is $1,000 and the increase in the value of the residence is determined to be only $700, the difference of $300, which is the amount in excess of the value enhancement, is deductible as a medical expense. If, however, by reason of this expenditure, it is determined that the value of the residence has not been increased, the entire cost of installing the elevator would qualify as a medical expense.”
Analysis of Treasury Regulation Section 1.213-1(e)(1)(iii)
Some of the key concepts suggested by the Regulation include:
1. “Which would not ordinarily be for the purpose of medical care” – this confirms that a broad category of expenditures may qualify.
2. “Exceeds the increase in the value of the related property” – As illustrated in the Regulation an appraisal or analysis of the impact of the improvements on the value of the property must be made. While practitioners often favor certified MAI appraisals on real estate matters the cost may be prohibitive and even exceed the tax benefit involved. Further, a local residential real estate broker that is active in the particular neighborhood where the client lives and made the improvements is likely to have the best knowledge of the impact on value. Courts have recognized and respected the valuation opinions of local brokers. The Ferris Court (see discussion below) is one example: “based upon the testimony of Mr. Geib, a real estate appraiser in Madison, we are convinced that the hypothetical [36 T.C.M. 768] structure would not have enhanced the value of the related property and probably would have decreased it.” 4
3. It is also interesting to note that the Regulation does not address any other impact but value. So even if an improvement makes the residence more saleable, e.g., as an added feature, that does not necessarily correlate with an increased value. Some expenditures might actually reduce the value of the home. For example, if a ramp were built in lieu of steps to the front door, some buyers may view that as a reduction in the home value as they might believe that they would have to restore the front of the home to its prior design. The Regulation does not appear to permit a netting of values. So if the ramp decreases the home’s value but an elevator increases the home’s value, can the two offset each other in applying the test? Perhaps if all of the improvements are part of a single plan to make a residence accessible the impact on value might be considered as one aggregate figure.
4. Related directly to medical care – the taxpayer should corroborate how the improvement/expenditure relates to the medical care of person involved. Likely a letter from a physician might be an important corroboration of the connection. Other approaches may also be feasible as the Regulation does not mandate a physician letter. There is a substantial body of literature, on the internet, in books, research papers and the like, that discuss how to make a home accessible. A more specific source of information might be to consult websites serving people with a particular disease, disability or challenge. Charities exist to serve a wide number of specific diseases and these charities often create resources to help those with the specific disease. So if a client has Parkinson’s disease for example, a website from one of the many Parkinson’s disease charities may have specific recommendations as to actions that can be taken to make a home accessible. WebMD and similar sites also have articles addressing these issues. The advantage of this approach to corroborate (or perhaps preferably supplement the corroboration provided by a letter from an attending physician) is that they are specific to the particular challenges the client has. For example the following information was identified by a google search for “home modifications Parkinson disease, from which the following items were excerpted: 5
Three tips for adapting your living room and bedrooms:
a. Invest in touchable lamps or those that react to sound.
b. Install handrails along walls, hallways, and stairwells where there is nothing to hold on to.
c. Objects such as a stationary pole or "trapeze" bar can be installed if you have difficulty getting out of bed.
Four tips for adapting your bathroom:
a. Use an elevated toilet seat and/or safety rails to assist standing from a low surface. Do not use towel racks or bathroom tissue holders to help you stand.
b. Put extended lever handles on faucets to make them easier to turn.
c. Install grab bars inside and outside the bathtub or shower.
d. Use a bathtub transfer bench or a shower chair with a back support.
5. “Taxpayer is advised by a physician” – the Regulation does not mandate a physician letter but it certainly is suggested.
Revenue Ruling 87-106 and Analysis
Much of the actual language of this seminar Ruling is reproduced below with comments and analysis added following the actual language of the Ruling. The comments and analysis are indented to differentiate them. The language from the Ruling is not presented in quotation marks as in some instances it is paraphrased or shortened.
The issue addressed in the Revenue Ruling is what capital expenditures incurred to accommodate a residence to a handicapped condition of the taxpayer, the taxpayer's spouse, or one of the taxpayer's dependents, are deductible in full under section 213 of the Internal Revenue Code.
The term “handicapped” obviously predates more appropriate descriptive terms. The term is defined according to one internet dictionary site as “having a condition that markedly restricts one's ability to function physically, mentally, or socially.” 6 There seems no reason to conclude that a restrictive definition is intended by the Ruling so that any chronic disease or health challenge that would warrant a home modification should qualify.
The Ruling provides the following analysis of the law concerning medical expense deductions:
Section 213(a) of the Code allows a deduction in computing taxable income for expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer, the taxpayer's spouse, or a dependent (as defined in section 152) to the extent that the expenses exceed 7.5 percent [now 10 percent] of the taxpayer's adjusted gross income.
Section 213(d)(1) of the Code defines the term “medical care” to include amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.
Section 1.213-1(e)(1)(ii) of the regulations provides, in part, that deductions for expenditures for medical care allowable under section 213 of the Code will be confined strictly to expenses incurred primarily for the prevention or alleviation of a physical or mental defect or illness. An expenditure that is merely beneficial to the general health of an individual is not an expenditure for medical care.
As with the definition of “handicapped” above the language “prevention or alleviation of a physical or mental defect or illness” also predates more appropriate and sensitive terminology. It should not be that the fact that home improvements will not “prevent” or “alleviate” a “defect” should not limit deductibility. Clearly the use of handrails and grab bars, which the Service permits (see below) does not prevent or alleviate any “defect” but merely might aid mobility or even just prevent a fall and injury. Those improvements are seemingly contemplated in the Ruling.
This provision of the Ruling sets forth some of the more important limitations taxpayers will have to grapple with. However, upon a review of the cited case, the holding of the Ruling is very favorable to taxpayers.
Ferris Case Analysis
In making a capital expenditure that would otherwise qualify as being for medical care, any additional expenditure that is attributable to personal motivation does not have medical care as its primary purpose and is not related directly to medical care for purposes of section 213 of the Code. Such personal motivations include, for instance, architectural or aesthetic compatibility with the related property. Consequently, such additional expenditures are not deductible under section 213. Ferris v. Commissioner, 582 F.2d 1112 (7th Cir. 1978), rev'g and rem'g T.C.M. 1977-186. In Ferris, the taxpayer had incurred additional costs for architectural and aesthetic reasons in building an enclosed pool that otherwise qualified as an expenditure for medical care. A deduction for the additional costs was denied.
The above limitation is an important one to factor into the analysis of what a client might deduct, but unfortunately the guidelines are not as informative as might be desired. For example, it seems clearly contemplated that the costs of installing grab bars would qualify. However, to properly install grab bars the wall surfaces have to be removed so that bracing (e.g., plywood or 2x4s) can be installed between the studs of the wall. Grab bars are quite important, and commonly installed, in bathrooms. This would require the removal of the sheetrock which in turn would first require the removal of the tile. It will be rarely if ever possible to replace existing tiles due to unavailability of older tiles, or even change in dye lots for recently purchased tile. Thus, the practical solution in most instances, and frankly one of the impediments to many needing such improvements, is the cost of removing and retiling an entire bathroom. Arguably, under the literal language of the Ruling replacing tile in the area of the bracing would be deductible but the remainder of the tile might be viewed as being done for “architectural or aesthetic compatibility with the related property.” However, this interpretation would emasculate the tax benefits of this provision. Further, it might be impossible when quoted a fee for a bathroom renovation to differentiate the respective costs. Finally, if a client is installing grab bars and the appropriate bracing, the same client might also be replacing regular bathroom tile floors with slip-resistant tiles at the same time. Thus, a rather significant portion of the retiling would appear to qualify for the deduction. At this point is it reasonable or practical to identify a portion of the cost that is only for “architectural or aesthetic compatibility with the related property?”
The Ferris Court found that non-essential items included space occupied by the steps at the deep end of the pool and approximately six feet of the width of the elevated sitting area. However, the Court found that a host of expenditures disallowed by the Service were in fact permissible. These included: “…the costs relating to the spiral staircase and the conversion of the screen porch which were necessary to minimize the distance petitioner had to walk to reach the pool, the sliding glass doors which were necessary to ventilate the pool area during the summer, the entrance steps at the shallow end of the pool, and certain intricacies of indoor pool construction such as water temperature, dew points and vapor barriers.”
In addition to this favorable allocation the Ferris court went much further. In the Ferris case the Court stated: “However, we are aware of no case limiting a medical expense within the meaning of section 213 to the cheapest form of treatment. For instance, if a taxpayer desires to stay in a private hospital room as opposed to a ward, or to patronize the most expensive medical institutions, the full amount of the expenditure qualifies as a medical expense. The ability to receive a tax benefit for any personal element of a capital expenditure having for its primary purpose the medical care of the taxpayer is substantially curtailed by section 1.213-1 (e)(1)(iii), Income Tax Regs., which limits the amount which may qualify as a medical expense to the difference between the total expenditure and the amount which the improvement enhances the value of related property. As a result of the limitation imposed by the regulations, approximately the same result is reached as under respondent's method of limiting the costs taken into consideration to those of a "bare bones" structure.” Thus, it is the fair market value limitation which is the primary restriction, not the taxpayer using more costly and better quality materials or designs.
Jacobs Case
In Jacobs v. Commissioner, 62 T.C. 813 (1974), the Tax Court held that for an expense to be deductible under section 213 of the Code it both must be an essential element of treatment and must not have otherwise been incurred for nonmedical reasons. An expenditure failing either test would be a nondeductible personal, living, or family expense under section 262. See Rev. Rul. 76-80, 1976-1 C.B. 71.
The “essential element of treatment” test seems incongruous with the intent of the statute. Grab bars, an entry ramp and many other common improvements to make a residence accessible, or safe, for a client with a disability, have nothing to do with the “treatment” of the disease. Yet these expenditures appear to be uniformly acknowledged as deductible. If the actual facts of the Jacobs case are reviewed, the impact of the decision on deducting home improvement medical expenses is negligible if not irrelevant. In Jacobs the taxpayer’s psychiatrist recommended that he divorce. The taxpayer did so and endeavored to deduct his legal fees in the divorce as a medical expense. To no surprise, the Court found them to be a non-deductible personal expense and not a medical expense.
Deductable as Medical Expenses
In S. Rep. No. 99-313, 99th Cong., 2d Sess. 59 (1986), 1986-3 (Vol. 3) C.B. 59, and 2 H.R. Rep. No. 99-841 (Conf. Rep.), 99th Cong., 2d Sess. II-22 (1986), 1986-3 (Vol. 4) C.B. 22, Congress expressed a desire to clarify that certain capital expenditures generally do not increase the value of a personal residence and thus generally are deductible in full as medical expenses. These expenditures are those made for removing structural barriers in a personal residence for the purpose of accommodating it to the handicapped condition of the taxpayer or the taxpayer's spouse or dependents who reside there.
The Internal Revenue Service has determined that expenditures for the following purposes generally do not increase the fair market value of a personal residence and thus generally are eligible in full for the medical expense deduction when made for the primary purpose of accommodating a personal residence to the handicapped condition of the taxpayer, the taxpayer's spouse, or dependents who reside there:
1. Constructing entrance or exit ramps to the residence
- This should include replacing a marble lintel at a door with new lintel with a Hollywood cut that makes it easier for a wheel chair to access the residence, and which reduces a tripping hazard.
2. Widening doorways at entrances or exits to the residence
3. Widening or otherwise modifying hallways and interior doorways
4. Installing railing, support bars, or other modifications to bathrooms
- See discussion above concerning tile and other modifications necessary to properly installing the supports for the grab bars, especially in light of the Ferris decision which is reviewed in detail above.
5. Lowering of or making other modifications to kitchen cabinets and equipment
6. Altering the location of or otherwise modifying electrical outlets and fixtures
- Similarly, lowering light switches should all be included
7. Installing porch lifts and other forms of lifts (Generally, this does not include elevators, as they may add to the fair market value of the residence and any deduction would have to be decreased to that extent. modifying fire alarms, smoke detectors, and other warning systems
8. Modifying stairs
9. Adding handrails or grab bars whether or not in bathrooms
10. Modifying hardware on doors
- A common application of this is replacing regular handles with lever handles.
11. Modifying areas in front of entrance and exit doorways
12. Grading of ground to provide access to the residence.
The Ruling continues on to state:
The above list of expenditures is not exhaustive. If substantially similar expenditures are incurred to accommodate a personal residence to the handicapped condition of the taxpayer or the taxpayer's spouse or dependents who reside there, those expenditures may be eligible in full for the medical deduction, provided they do not increase the fair market value of the personal residence. Moreover, only reasonable costs incurred to accommodate a personal residence to the handicapped condition are considered to be incurred for the purpose of medical care or are directly related to medical care for purposes of section 213 of the Code. Additional costs attributable to personal motivations are not deductible under section 213.
Subject to the percentage limitation of section 213(a) of the Code, the above capital expenditures incurred to accommodate a residence to the handicapped condition of the taxpayer, the taxpayer's spouse, or one of the taxpayer's dependents generally are deductible in full under section 213 provided that the residence is the personal residence of the handicapped individual.
Additional Considerations
Amounts you pay for operation and upkeep of a capital asset qualify as medical expenses, as long as the main reason for them is medical care. This rule applies even if none or only part of the original cost of the capital asset qualified as a medical care expense.
Oliver Case Discussion and Analysis
In W. Lawrence Oliver and Hazel P. Oliver v. Commissioner, the Court did not object to a wide range of costs but rather to the fact that the taxpayer himself made the determinations as to the value which the improvements added to the value of the home. The taxpayer clearly had a vested interest in the outcome and was a practicing attorney, not a real estate professional. Further, it appears that the taxpayer provided inadequate corroboration of the costs incurred. The case is in part instructive in how not to handle a claimed deduction for medical improvements to a home. The indication of the types of expenses may also prove of interest to practitioners.
In the Oliver case 7 Mrs. Oliver has been under treatment for multiple sclerosis, the taxpayers built a new home which contained many special features designed to make things easier for Mrs. Oliver and to aid in her care. Among other things, the house had wide doorways to accommodate a wheelchair, air conditioning, a communication system and a built-in stereo system. A motor-driven hospital bed was installed. At the trial Mr. Oliver, claiming to have had experience as a real estate appraiser, stated the cost of special ramps and doors without increasing the value of the house. Similarly, he claimed that the air conditioning system cost $1,200 and added only $600 to the fair value of the house. The intercom system cost $800 and added only $500 to the fair value of the house. The stereo system cost $5,000 and added $2,000 to the value of the house. He also asked that the entire $600 cost of the special bed be deducted. The Tax Court held $900 of the cost of the special features in the house and $500 of the cost of the bed were proper deductions but denied the remaining claimed balances.
Home improvements, which aid in medical care as defined in Section 213 of the Internal Revenue Code, are proper medical deductions to the extent that they do not increase the value of property. The problem in the Court’s view was that Mr. Oliver, except for his testimony, made no proof of the costs of the special features of the home built, nor of the extent to which any such costs did not increase the value of the home. While he said he had experience as an appraiser of real estate, there was no corroboration of that claim. The Court held that some part of the costs of the special features of the home were allowable as medical expenses. Exercising its judgment, the Court found that $900 of the cost of the special features of the home and $500 for the special bed were allowable as deductions for medical expenses in 1960. The Court was clearly troubled by Mr. Oliver’s lack of professional qualifications and found his testimony “improbable, unreasonable, or questionable”. The Court also noted that Mr. Oliver had a direct interest in the outcome of the proceedings. Because of his self-interest, the Tax Court, as the arbitrator of credibility, may disregard his testimony or, as here, reduce his valuations.
Lipson Case Discussion and Analysis
The Marvin Lipson and Rose C. Lipson v. Commissioner case presents another example of what not to do when endeavoring to claim a medical expense for home improvements. Most significant, the taxpayer provided little substantiation that his claimed allergies to dust and cats justified the improvements, and there was inadequate medical corroboration for the conditions and improvements. 8 The primary cost incurred as a forced air system to deal with the taxpayer’s asthma.
The “medical” letter provided by the taxpayer was as follows:
To whom it may concern
This will certify that I have advised Marvin Lipson to have air conditioning with filters installed in his home for medical reasons.
/s/ Walter L. Palmer
The second statement typed on the doctor's letterhead stationary reads as follows:
February 13, 1984
MEMORANDUM
This memorandum is being written at the request of Mrs. Rose Lipson who has been a patient of mine since January 1971. During this period of thirteen years, I have had considerable contact also with her husband, Marvin Lipson, and have on occasion written prescriptions for him as well as for her.
* * *
I also recommended the use of Alupent inhalant and the installation in his home of an air conditioning system with air filters as per my handwritten note of May 4, 1978.
/s/ Walter Palmer, M.D.
Very Truly Yours,
The Court, unsurprisingly, did not find these documents convincing.
Conclusion
As clients age and the incidence of chronic disease and disabilities increase practitioners should give more attention to the potential for a tax deduction for home improvements made to adapt a home to meet the client’s medical needs. As the preceding analysis demonstrates a wide range of expenses may qualify, but care has to be exercised in corroborating the medical need and that the expenses are not deducted to the extent they increase the value of the home.
1 http://www.aoa.gov/AoARoot/Aging_Statistics/future_growth/aging21/health.aspx. August 5, 2014.
2 Rogers, S., & H. Komisar. Who needs long-term care? Fact Sheet, Long-Term Care Financing Project. Washington, DC: Georgetown University Press, 2003, cited at https://www.caregiver.org/selected-long-term-care-statistics. August 5, 2014.
3 AARP. Beyond 50.2003: A Report to the Nation on Independent Living and Disability, 2003, http://www.aarp.org/research/health/disabilities/aresearch-import-753.html (11 Jan 2005), cited at https://www.caregiver.org/selected-long-term-care-statistics. August 5, 2014.
4 Ferris v. Commissioner, 582 F.2d 1112 (7th Cir. 1978), rev'g and rem'g T.C.M. 1977-186.
5 “Web MD contained an article “Adapting Your Home for Parkinson's Disease,” Aug. 5, 2014 at http://www.webmd.com/parkinsons-disease/guide/parkinsons-home-safety.
6 http://dictionary.reference.com/browse/handicapped. August 5, 2014.
7 W. Lawrence Oliver and Hazel P. Oliver v. Commissioner 283 U. S. 223, 227-229, 51 S. Ct. 413, 75 L. Ed. 991 (Aug. 2, 1966).
8 Marvin Lipson and Rose C. Lipson v. Commissioner, T.C. Memo. 42,295(M), 50 T.C.M. 692, T.C. Memo. 1985-409, (Aug. 12, 1985)
Martin M. Shenkman, CPA, MBA, PFS, AEP, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.
Write comment (1 Comment)- Details
- Written by: Martin M. Shenkman, CPA, MBA, PFS, AEP, JD
Every CPA can and should be a proactive to help clients with estate planning matters. In the past, many CPAs shied away from this vital role, to their client’s detriment, and to theirs. Of all the members of a client’s estate planning team, more often than not it is the CPA, not the attorney or investment adviser, that has a long term relationship. The knowledge and position of trust that this relationship can provide, makes the CPA the preferred adviser to broach tough estate planning topics with clients. The tough topic is not saving estate taxes, which for all but 3,000 or so estates a year is academic. The toughest topic for clients to focus on is not only the most important for the client, but also one squarely within the expertise of the local CPA practitioner. The “hot topic” is later life planning. CPAs can guide clients to use Quicken, or any personal checkbook program to address many of the critical and practical issues of later life planning that otherwise are ignored. In coming years this will represent a growing practice opportunity for the local practitioner. It will fill a planning void many clients need addressed.
What Is Later Life Planning and How Can the Local Practitioner Help?
Later life planning is the future of estate planning for the aging client not subject to a federal estate tax. Consider how each of the issues or steps below creates a practice development opportunity:
- What steps can the client take to assure that he or she will remain in control over his or her assets for as long as possible?
- While the prior generation of estate planning clients was focused on saving estate taxes on the wealth they spent a lifetime accumulating, the Boomer clients who are the next vanguard of estate planning clients are focused on assuring they will have adequate cash flow for the duration of their lives. This is not only a result of the demise of the estate tax but more so a result of increasing longevity. These clients need realistic budgets that are monitored as part of an integrated financial and investment plan to assure that clients stay on course over this long time period.
- As a client ages, and everyone knows the population is aging, what can be done to minimize the risks of elder financial abuse. Whatever the statistics on financial abuse indicate, this author’s belief is that most elder financial abuse is undetected, and of those situations that are identified, most are unreported because either family is involved, or there is no one adversely affected that has knowledge of the situation.
- Most if not every estate plan includes the preparation and execution of a durable power of attorney to name an agent to handle financial matters in the event of the client’s disability. Yet it is rare that anything is done to address the practicalities of an agent actually using a power of attorney.
The “I Don’t Use a Computer” Smoke Screen
How can the practitioner harness the power of Quicken to accomplish all of these and other goals? Today’s retiree is likely comfortable using a computer and Quicken, more or less. For those “less” more assistance can be rendered. For older clients that are not as computer comfortable, a CPA can maintain computer records for the client and in many cases the children or agents will be computer savvy and appreciate the security and other benefits. Many older clients have a child or other person handling their finances, if the CPA can fill part of the role by maintaining detailed records, that “helper” will be incredibly appreciative. So don’t dismiss this role and opportunity because some clients are not tech savvy, that deficiency only makes the CPAs assistance more important.
Checklist: Harnessing Quicken – A Cornucopia of Services
√ Reminders
Reminders can easily be set in Quicken so that clients don’t overlook important bills. If the client is uncomfortable setting these up, the practitioner can easily help do so. But the benefits of this feature go well beyond paying a monthly mortgage. The more important items to schedule reminders are for those non-monthly items that are more readily overlooked. Further, the reminders should include a wide range of vital financial and estate planning steps, not simply bill paying. A carefully thought out reminder list, updated perhaps every few years, can be invaluable. Also, as clients age it is more difficult to remember important items. If a child or other loved one helps a client with their medical care, finances or other matters, this reminder list might serve as a checklist for a semi-annual “check-up” when they meet with mom or dad. Consider the following as possible reminders to discuss with a client to assure that the list is comprehensive. Obviously, each client will have his or her own unique nuances:
1. Mortgage payment.
2. Property tax payments quarterly (on the town’s fiscal year basis).
3. Colonoscopy every five years.
4. Annual physical.
5. Order one free credit report every four months during the year from each of the three credit reporting agencies.
6. Annual mammography.
7. Dental and other appointments.
8. Meet with investment adviser semi-annually.
9. Meet with estate planner every three years.
10. Annual renewal of local town license for dog or other pet.
11. Quarterly tax estimates.
12. Change smoke detector batteries annually.
13. Change oil in emergency generator.
14. Expiration dates for term life insurance conversion features.
15. Start date for a deferred annuity.
16. Reminder to have CPA and investment adviser review gain/loss harvesting before year-end.
17. Distributions from investment limited partnerships.
18. Capital calls on private equity investments.
19. Review property and casualty insurance coverage limits every other year.
There is no rule that Quicken reminders cannot be used to assure a client does not forget any important life event. The listing of reminders is a great tool for the client to review with anyone helping advise him or her to assure that all key events are listed.
√ Budgeting
As every practitioner and client knows a financial plan requires a realistic budget and an investment plan built on financial targets (e.g., a grandchild’s wedding) and that budget. Too often, however, budgets are based on computer assumptions or wild guesstimates since the client does not provide any hard data. When a client has no computerized records, culling actual expense data from a manual check book (assuming the client even keeps that, as many do little recordkeeping) and non-existent receipts for ATM withdrawals and cash expenses, will be difficult or impossible. Once a client’s checkbook and other financial transactions are computerized, it becomes a simple task to generate current and prior year expenditures by category. These can then be reviewed and adjusted for unusual items, or to reflect future expense matters. But the key is that the figures used as the foundation of the budget and financial projections will be grounded in reality, not in some “Clever-esque” fiction of what some American family supposedly spends.
Once the plan is completed, the details of an actual budget will give the client the data to identify expenses that are the least painful to cut if that is what is required.
Once the process is completed, it can be templated so that the budget and financial projections, paired with a Monte Carlo simulation of financial outcomes, can be updated and repeated every year or two so that changes can be incorporated and the plan fine-tuned to stay on track.
While this is all simple and obvious far too few clients engage in these fundamentals of planning. While there is no statistical data to support this, it seems to this author that the wealthier the client often the less likely this process is pursued, as if one of the luxuries of wealth is not to have to worry over budget nuances. The reality is that many very wealthy clients spend at a rate that will likely undermine their financial security over their actual lives (in contrast to mere life expectancy). So practitioners that can facilitate clients pursuing this planning may well be the key to the participating client’s financial security.
While these more traditional and obvious applications of budgeting and planning, based on Quicken data, can be incredibly useful, there are many significant non-traditional uses of Quicken financial data as described in the planning tips following.
√ Automation
Estate planning doesn’t have to only focus on depressing scenarios of death and disability. Many clients, especially Boomers, plan active post “retirement” years. The term “retirement” is in quotes because many Boomers plan to continue working in some manner after the traditional retirement age of 65. So if an active Boomer is off on safari, how will bills be paid? When a Boomer is hiking the Appalachian Trail, how will her property taxes be paid? The more obvious planning scenarios must then be addressed. The fact that they might be obvious to practitioner and client alike doesn’t suggest that many clients actually address them. In the event of disability, who will handle payments? How, if a client faces physical challenges, will they make bank deposits? The solution to all of these scenarios is to automate as many financial transactions as possible. Consider:
1. Every recurring bill that can be automatically charged to a credit card, should be set up to be so charged.
2. Every recurring bill that cannot be charged to a credit card should be set up to be automatically deducted from the client’s checking account.
3. Every credit card that can be automatically paid from the client’s checking account should be set up for automatic payment.
4. The client should establish overdraft protection on the checking account used to avoid any insufficient funds.
5. All deposits that can be made automatically to the client’s checking account should be set up for automatic deposit.
This type of planning accomplishes a wide array of benefits. Consider:
1. If the client develops cognitive issues, there are far fewer transactions a month to process. It is easier to monitor routine automatic transactions then to process the entire transaction.
2. Automatic payments and deposits reduce the mail, bills, and other documents and transfers that create opportunities for identity theft or elder financial abuse.
3. If the client is disabled, the transition from the client handing his or her affairs to the point of an agent stepping in to handle the client’s financial and other affairs is rarely clean or simple. The more automated transactions are the fewer dropped balls will occur during that period.
4. The agent taking over these matters will have a far easier time understanding his or her responsibilities if many transactions are automatic, so that there is a clear paper trail of what is happening.
5. Automation will also minimize the time the agent will have to devote to assisting. Most estate planners as well as clients give little attention to the time demands serving as a fiduciary will require. When a client names an adult child to serve in this capacity, that child may have significant work, family and other responsibilities. So no matter how honest and financially astute, whatever can be done to minimize the time demands of serving as an agent under a parent’s power of attorney is likely to be appreciated and enable the child to do a better overall job. In the more extreme situations of a parent with a long term disabling disease, such as Alzheimer’s disease, which might result in a child serving as an agent for a decade or even decades, the simplicity that automation creates may be vitally important for the family.
Automation of a client’s routine finances is one of the most important steps to safeguard a client in his or her later years. Yet this vital guidance is often lacking as each professional adviser assumes that this is too mundane or simple to address, or that another adviser of the client’s has addressed it.
√ Reports to Monitor Client
Once a client’s finances have been automated periodic monitoring of Quicken records can provide incredible protection for the client. Frequently estate plans presume that a client will be well, and then either become incompetent or die. The reality for many is a myriad of shades of gray in terms of the client’s cognitive and physical abilities, shades that change often significantly. Disability is rarely a clearly demarcated event. As such, monitoring a client to identify the declines leading to disability, or the troughs in what might be a rollercoaster of health fluctuations from relative wellbeing to significant disability during an attack or flare up of a chronic disease and back to relative wellbeing. Consider the following:
1. Analyze living expenses and compare on a year-to-year basis and generate budgets and observe the variations from budget to actual. This may reveal a mere innocuous change in spending patterns, or something much more significant, perhaps even sinister.
2. A detailed print out of medical expenses from Quicken can readily help a care manager or family member assisting in the care of an aging client identify if the client has forgone semi-annual dental visits or other care. It may also identify whether the client has relied on out-of-network health care providers at excessive cost. The payees may provide a valuable listing of medical providers to which a care manager may wish to seek reports in order to properly assess the client’s health care and to create a care plan. While this information might be gleaned from paperwork the client has retained, the Quicken records, especially in light of the ubiquitous co-payments, may prove a good test of the completeness of those records.
3. What has the client’s expenditures on food been and where have they been made? Such simple sounding data could be incredibly important for a family member endeavoring to monitor the client’s wellbeing at a distance. If the food expenditures decline precipitously it might indicate that an elderly client is not eating enough. This could indicate depression or apathy, common symptoms of many chronic diseases that affect the elderly. It could indicate cognitive or physical decline that makes securing adequate food difficult. Perhaps a home aid that is supposed to be purchasing food is stealing the money or simply not performing services as needed. Even the composition of the payees may indicate an important change.
4. Investment abuse is a common component of elder financial abuse. If the Quicken records indicate a deposit on a land purchase or private equity investment is that really appropriate and intended or is it a sign of an insidious turn of events? Does the sudden appearance of large annuities or life insurance policies indicate an appropriate change in investment planning or is it a sign of a financial adviser taking advantage of the client?
Practitioners can use www.gotomypc.com or other services to patch in remotely to the client’s laptop to review these matters. If the client’s excuse is that he or she does not have Internet access, then the client is also not taking advantage of a host of other inexpensive and practical steps to safeguard themselves. Alarm systems, video cameras and other security devices are cost-effective and practical, even essential for aging clients, especially those with health challenges. Age or illness may impede the client’s sense of smell, hearing and other sensory abilities. A smoke detector, glass breakage detector and other monitoring devices connected to a central alarm system may be essential. The panic buttons for a client to call for help in the event of a fall (think of those infamous TV advertisements “Help, I’ve fallen and I can’t get up”) may all work best with an Internet connection. The point is simple; the objections clients might raise to any of this assistance are usually signs of other, perhaps more significant, issues that should be addressed. While a practitioner might view a discussion of Internet connections and alarm and security devices outside of his or her purview, who is addressing these essential later-life planning issues? Often no one is addressing them.
√ Road Map for Agents
So a client is disabled and his daughter, a corporate attorney, is named as agent under the client’s durable power of attorney. The daughter has more than adequate sophistication to address any of the financial and legal issue that might arise.
1. But where does she begin?
2. What expenses does she have to pay for her now incapacitated father?
3. Where can she find out?
4. In most cases there are manual checkbooks of questionable completeness, random cash receipts, perhaps a year old tax return that is far too broad in scope to address the specifics involved.
5. Certainly the daughter can cull the mail to identify bills to pay and deposits to make, but that is not a simple task.
6. If the father has been subject of elder financial abuse as his cognitive abilities have declined, the mail may have been compromised.
7. What bills was the father receiving by mail?
8. Which by email?
The simple and practical solution would be for the father, when relative well, to have automated his checkbook and related records. If that had been done a simple Quicken report of activities by category could reveal exactly what types of expenses should be paid. Simply put the best road map to facilitate anyone serving as a fiduciary, whether as agent under a durable power of attorney, successor trustee under a revocable living trust, or in many other capacities, are the Quicken reports any accounting practitioner can readily assist the parent in setting up.
√ Reports of Agent’s Activities
Much has been written in the professional literature about planning and drafting durable powers of attorney, but comparatively little about their actual use. As the population ages, elder financial abuse grows, and families continue to be less unified, the likelihood of lawsuits against agents for their actions under powers of attorney is likely to grow. Practitioners can be of incredible assistance to minimize these risks faced by those serving as agents, and thereby help the families and others effected. Consider:
1. Encourage (insist if possible) that agents meet with an estate-planning attorney to review the power of attorney. Certainly the client (the “principal” or “grantor” under the power of attorney) reviewed the legal document with his or her estate-planning attorney when the document was planned and signed. However, the person serving as agent is generally not involved in any of those meetings. Just as significant, the focus of the discussion in those meetings is quite different. When a client is well and discusses a power of attorney, often attention is given to who the agent is, whether a gift power should be used, how many documents to sign, where they should be kept and other concerns. When an agent steps in to act in a fiduciary capacity the focus should be on what expenditures to make, what assets should the agent marshal, and so forth.
2. What are the circumstances under which the agent is acting under the power of attorney? The agent might be one child (sibling, niece/nephew) among many. The expenses will likely reduce the future inheritances of those other persons not serving as agent. That creates a real (not theoretical) conflict of interests between the agents and the others that may be affected. This conflict can be dramatically heightened if the durable power of attorney has a gift provision. Who can or should the agent make gifts to?
3. If the agent expends significant money on an experimental medical treatment will the other heirs have a claim for misuse of funds? What if the agent under the financial power of attorney is a different person than the person serving as health proxy? If the person serving as health proxy does not authorize the experimental medical treatments should that change the appropriateness of the agent’s expenditure?
4. The reality is that few agents formally report what they do to anyone. In some instances it might actually be advantageous for the agent to have an attorney petition a court for agent to be appointed as a guardian of the client’s property so that there is court supervision over the expenditures.
5. Whatever is done, what role can an accounting practitioner have in all of this? A tremendous role. Regardless of the circumstances, if the agent retains an independent accountant to record and report the income and expenses to all those who may be affected, it might significantly change the perception of the other heirs and deflect later challenges. This author’s experience has been that one of the common triggers for disgruntled family members (or other heirs) is lack of information. When someone has no idea what is going on, has received no formal communication, they will often assume the worst. And why shouldn’t they if no relevant information has been provided? Siblings often resent that another sibling was named agent before them, or even more so, instead of them. Starting with that feeling, and then compounding it by the sibling serving as agent not informing them, the resentment, frustration and eventually anger, often foment. If instead an independent accountant provides a professional periodic summary of all financial transactions that the agent has made to all affected parties, several results might occur. First, the resentment and suspicions that often drive later family feuds or legal action, may be avoided altogether. Since often these issues never arise formally until after many years have passed, the affected heir complaining will be in a much different position. It will be difficult to argue non-disclosure or inappropriate expenditures when they have received detailed reports prepared by an independent accounting for all intervening years. Perhaps most important, if an accounting practitioner is involved in the process, professional guidance as to expenditures, proper recordkeeping, contemporaneous records, appropriate tax reporting and more, are all likely to be addressed. These are items that while simple and obvious to all accountants, are likely to be overlooked by a non-professional.
6. If the agent is charged with investing the client’s funds, which many if not most are, what investment plan will be pursued and how will it be documented. The CPA practitioner can guide the client to either retain appropriate professional investment counsel and/or create an investment plan and memorialize it in an investment policy statement
7. Much of the above can be based on using data from the client’s Quicken records and guiding the agent to maintain those records while serving in a fiduciary capacity.
Proper recordkeeping and reporting by fiduciaries for our aging population is a practice opportunity that will grow significantly in the future. But the first step to this work is educating clients that those serving as their agents had best retain professional accounting guidance.
√ Gifts Historically Made
A common provision in many powers of attorney is to permit the agents to make gifts. Many standard forms as well as attorney prepared documents have language that in some form permits the agent to make gifts to individuals or charities that the client has historically made gifts to. How can one determine to whom gifts were historically made? While a Form 1040 might be useful for purposes of charitable gifts, Quicken reports should provide a comprehensive listing of all gifts to all people that can support the actions of an agent.
Conclusion
A local practitioner with a modicum of effort reviewing a client’s expenditures can often identify a range of significant life changing events before anyone else is aware of them. Expanding estate planning services into the arena of later life planning to help safeguard and secure a client’s future can be a great practice development opportunity for the practitioner, and literally a lifesaver for the client. In most cases clients will be reticent to address this type of planning. They will believe they are not in need of these services, that the cost is too great, and more. The range of excuses proffered will likely be creative and even amusing. The reality is that no one knows when and to what extent their cognitive or physical skills will begin to decline, or when that decline; will expose them to abuse or other problems. Identity theft and elder financial abuse are not burgeoning because the American public has taken every prudent and practical step to protect themselves. They are exploding in occurrence precisely because most people don’t act until it is too late.
Martin M. Shenkman, CPA, MBA, PFS, AEP, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.
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- Written by: Martin M. Shenkman, CPA, MBA, PFS, AEP, JD
LLCs are ubiquitous in tax and business planning for clients. They have become the default answer to questions like “how to I organize my new business,” or “I’m buying a rental property, how should I do it.” However, LLCs are an incredibly flexible planning tool, a veritable Swiss Army Knife of planning options, that can be molded to meet a wide range of planning goals. The checklist below discusses many common, and not-so-common, planning applications of LLCs. Some of the applications of LLCs are obvious to practitioners, yet many clients still fail to heed the common advice as to how and when to use them. Although these situations are well known, they’ve been added to this checklist to encourage practitioners to proactively address them with clients. Finally, while the changes made by the American Taxpayer Relief Act of 2012 to the estate tax may have been permanent (whatever that word means in Washington) there are seemingly always changes in the law and tax environment that affect planning. The changes that have occurred in recent years make it imperative that every client with FLP/LLC have a check-up meeting. Some of these points are noted as well.
√ Consolidation LLCs
It is common for client families to accumulate various investment accounts. Whereas in the past the use of FLPs and LLCs to hold investment assets was largely focused on securing estate tax discounts, these discounts may not be important to most clients. However, the other significant benefits from this application of FLPs/LLCs remains a valuable planning tool for many. Practitioners should consider:
- Consolidating many family accounts into a single investment entity may enhance investment opportunities and be used to lower overall investment management fees.
- A properly structured and operated FLP/LLC can provide family members important asset protection benefits. A multi-member entity will afford partners/members charging order protection in the event of a personal lawsuit. This could be instrumental in protecting what might otherwise be fully exposed and easily reached investment assets.
- If the parent or another specified person serves as general partner or manager of the investment entity it may negate arguments in a matrimonial case that the a child actively invested assets somehow transforming them into marital assets.
Practitioners reviewing Forms 1040 Schedule B should be alert for large investment income that is owned individually when a family entity could instead afford significant benefits.
√ Home Ownership
While the use of an LLC to own rental properties is common, there are some special circumstances when a client might wish to use a special adaption of an LLC to own a home. This might be appropriate in at least one unusual circumstance. The clients are very concerned about asset protection and the state where the residence is located does not afford any homestead or tenants by the entirety (husband and wife as owners) protection for a home. In these instances having a multi-member LLC own the home may address that issue. The home might be owned for example, 40% husband, 40% wife, 20% family trust. In many instances the cost of this type of structure, or the negative implications to home sale exclusion or mortgage interest will negate the planning. However, in some instances this might be the ideal tool.
√ Vacation Home Ownership
The client owns a vacation home in a state that has an estate tax so that owning property directly or in a living trust might leave that property subject to a state estate tax. However, if the property is owned by an LLC, and the client is domiciled in a state that does not have a state estate tax (or if it does, for which the client will not be liable), the LLC may also achieve the client’s tax planning goals and avoid ancillary probate as well.
When these “off-label” applications of LLCs to own homes are used, be certain that the attorney modified the legal documentation accordingly since typical commercial operating agreement provisions might make little sense in this context.
√ Home Based Business
Organizing a home-based business as an LLC is an obvious and common tool every practitioner is familiar with. The problem is that too many clients ignore practitioners’ advice to form an LLC for a “small” home based business worrying about the cost of creating the entity. The size of a home-based business has no correlation to the potential liabilities it can create. Anytime a practitioner files a Form 1040 with a Schedule C or E that includes a home based business or rental property that is not in an entity format (LLC or otherwise) consider sending a standard letter (or even email) cautioning the client that they should form an entity and that regardless of the profitability or revenue of the business or property, liability may exist.
√ Single Member LLCs
While it may be obvious to every practitioner that a single member disregarded LLC does not afford the asset protection that a multiple member LLC does, many clients ignore practitioners advice to use a multiple member LLC worrying about the cost of the annual Form 1065. Again, this is a common mistake that puts many clients at risk. If a client is sued the interests in a 100% LLC are fully reachable by a claimant of the client. However, if the LLC is a true multiple-member entity then the client’s interests may be attached generally by a claimant. The claimant, however, may not be able to force the liquidation of the entity to seize on the interests involved. As such, the client has greater protection from suits. Anytime a practitioner files a Form 1040 with a Schedule C or E that includes a single member disregarded LLC consider sending a standard letter (or even email) cautioning the client that they should reform the LLC as a multiple member entity to provide better protection.
√ Child Funds
In many cases a child accumulates significant assets from gifts. These assets might then prove a temptation to the child to inappropriately or even dangerously use the funds. Large funds might be a temptation for a young client’s significant other or other predators or creditors. Ideally, gifts and other transfers should be made in trust for any minor beneficiary. Too often, however, clients ignore the advice of their professionals, or don’t realize the significant amount the funds will grow. After the fact the only trust structure that may be feasible is a self-settled trust. This would require that the client establish a trust in a jurisdiction permitting self-settled trusts (e.g. Delaware). This technique is complex, costly and embodies risks that many clients are not willing to assume. A simple family LLC might offer a practical and low cost option. Consolidate these assets into a family partnership or LLC. This may be an ideal tool to provide a measure of control and protection for these funds with the complexity and cost of a self-settled trust. If the child is a minority owner of the entity the manager or GP can provide brakes on distributions, asset protection, distance from a gold-digging spouse/significant other, etc.
√ Charity and LLCs
LLCs have not been used to a great degree by charities to insulate them from liability risks of donations. That may change. The change may open up greater possibility to help clients structure more complex charitable gifts. A charity may want to form a single member LLC that it owns and controls so that the activities conducted by the LLC do not subject the charity to liability, such as from accepting a donation of rental real estate. The IRS in 2012-52, confirmed that so long as all other requirements of IRC § 170 are met, the IRS will treat a contribution to the disregarded single member LLC as a tax-deductible contribution to the charity itself for income tax purposes. This option can provide a creative use of LLCs to facilitate client charitable planning especially for clients owning business or real estate interests. Practitioners should be certain that the charity discloses in the acknowledgment of the donation that the single member LLC is wholly owned by the charity and treated by the charity as a disregarded entity.
√ Charitable FLPs
While some uses of charitable partnerships have been abusive, there are planning opportunities that might be viable if properly implemented. The use of this technique is perhaps most readily explained by example. A client could create a family limited partnership (FLP). The client will own 100% of the entity that is a 1% general partner (GP). Initially, the client could own the 99% limited partnership (LP) interests (although a spouse and/or adult child could also own LP interests). The client contributes appreciated assets to the FLP. Thereafter, the client/donor would contribute some or all of the LP interest to a public charity (the self-dealing restrictions applicable to private foundations make them inadvisable to use). The client should realize an income tax charitable contribution deduction for the contribution of the LP interests at the appropriate discounted fair market value. This amount should be determined by a qualified appraisal. Treas. Reg. §1.170A-13. The FLP may then sell appreciated assets and capital gains should flow through to the then owners: i.e. perhaps up to 99% to the tax exempt charity, and 1% to the GP. If this sale was pre-arranged it would not past muster. Eventually, the charity may be willing to sell the LP interests for their fair market value to a family trust, such as a family dynasty trust. Even if the assets are not sold, and there is no capital gains minimization (which may eliminate a risk that some practitioners are uncomfortable with), the client could transfer value to a charity and obtain a contribution deduction, and also transfer value to the family dynasty trust leveraged for gift and generation skipping tax exemption purposes.
√ LLCs May Need to Supplement Asset Protection Trusts
Domestic asset protection trusts (“DAPT”) have been subject to a number of unfavorable cases. In re Huber, 2013 WL 2154218 (Bankr. W.D. WA, May 17, 2013), Battley v. Mortensen, Adv. D. Alaska, No. A09-90036-DMD, May 26, 2011 and Rush Univ. Med. Center v. Sessions, ____ N.E. 2d ____, 2012 IL 112906, 2012 WL 4127261 (Ill, Sept. 20, 2012) to name a few. Other types of irrevocable trusts that might be intended for asset protection may also face challenges for other reasons. So, if asset protection is a concern of your client, and the client has existing irrevocable trusts, layering LLCs onto the irrevocable trust plan may provide a backstop to the protection hopefully afforded by the trusts. Assuring that the documentation for these LLCs, if they already exist, is current may be an important planning step. There are a host of other asset protection considerations for existing client LLCs, and opportunities to creatively use an LLC to achieve asset protection benefits.
√ Many LLCs Need Service Calls
Whether or not it’s been 5,000 miles since your client’s LLC “oil change”, many LLCs are overdue for a service call. There have been a number of significant legal changes that make it advisable for every client to review their LLC operating agreement (the legal document governing the operations of the entity) and other aspects of their LLC structure and planning. While CPAs are not going to review the legal aspects of this, the tax aspects are vital. But as with so many planning areas, if the CPA doesn’t lead the client to the lawyer the work will never be addressed and the client will remain unprotected.
The Revised Uniform Limited Liability Company Act (“LLC Act”) was adopted into law in a number of states including Iowa, Idaho, Utah, Wyoming, Nebraska, New Jersey, California, and the District of Columbia. For LLCs in these jurisdictions the changes in the law could have an important impact and it may be advisable to take action. Every client in these states should meet with their attorney and review their documents. Some of the comments below are based on the New Jersey law changes, but the key point is that any client who has not reviewed their LLC documents in recent years should do so:
- Creditor’s Rights
The LLC Act permits a creditor of a member (e.g., a physician member’s malpractice claimant) to foreclose on the LLC membership interest. This can undermine LLC protection in a significant manner. Forming new LLCs in states with more favorable laws might make sense. While cumbersome, it may be feasible to convert or reform an existing New Jersey (or other state with similar laws) LLC in a better jurisdiction. For clients worried about lawsuits this is vital to address.
- Written Agreement
The LLC Act permits an LLC operating agreement (the legal document that governs the management and operation of the LLC) to be in writing, oral or even implied based on how the LLC operates. This might make it more important to have annual review meetings, written consents and appropriate amendments of written operating agreements to minimize any unintended implication that another arrangement superseded or modified the existing operating agreement.
- Statement of Authority
The LLC Act permits an LLC to file a document, referred to as a “statement of authority,” with the State Treasurer specifying individuals or entities whom have (or don’t have) the authority to execute agreements transferring LLC real estate, or entering into any other transactions on behalf of the LLC. This might be useful to certain LLCs, perhaps those with independent parties who want to assure who can or cannot bind the LLC legally. In the family context, the use of this mechanism should be considered in a tax context as well. For example, might naming a person to hold authority to sell real estate affect the characterization of the LLC for purposes of the passive income or loss rules under IRC Sec. 469, or the Medicare Surtax Rules under IRC Sec. 1411? Might naming a parent who made gifts of LLC interests to hold authority to sell real estate or a business of the LLC be argued by the IRS as a retained right that could cause estate inclusion under IRS Sec. 2036? While this mechanism might provide a useful simplification for real estate and business transactions, its use should first be reviewed in the broad context of your overall planning.
- Fiduciary Duties
Under the LLC Act, the Operating Agreement cannot eliminate or restrict a member or manager’s fiduciary duties unless it is not manifestly unreasonable. If an existing operating agreement has restrictions that may run afoul of this criterium, amendment may be appropriate. Also, those members or managers that are affected may wish to reassess their level of involvement if a change is warranted. Caution should be exercised in family LLCs in that restricting fiduciary responsibilities could have tax ramifications. For example, if a parent made gifts of LLC interests and the operating agreement restricts the parent’s fiduciary responsibilities as a manager or member the IRS may argue that the restrictions permit excessive control by the donor/parent and may therefore support an argument of estate inclusion. The operating agreement may include a mechanism by which a particular transaction that would otherwise violate the duty of loyalty may be approved by a disinterested and independent person, after full disclosure of all material facts. This may be a concept that is worthwhile to integrate into some LLC arrangements.
- Indemnification
Under prior LLC law the LLC operating agreement could alter or eliminate the indemnification for a manager or member. The LLC Act provides that the Operating Agreement may eliminate or limit a member or manager’s liability to the LLC and members for money damages, except for: (1) breach of the duty of loyalty; (2) an unentitled financial benefit received by the member or manager; (3) an improper distribution; (4) intentional infliction of harm on the LLC or a member; or (5) an intentional violation of criminal law. It is advisable to review the indemnification and related provisions to assure that the standards of the LLC Act are acceptable, and if not whether the operating agreement should be modified to address these matters. It may be advisable to review your liability, errors and omissions and other insurance coverage to confirm what is in fact addressed in your policy.
- Resigning Member Rights
Under the LLC Act, a resigning member of an LLC is no longer entitled to the “fair value” for his LLC interest as of the date of resignation. Instead, a resigning member disassociates himself as a member and will only have rights as an economic interest holder (i.e., he will retain an equity interest but forfeits his voting interest).
- Oppressed Member Rights
The Revised LLC Act allows a member of an LLC to apply for an order from the Court dissolving the LLC, or appointing a custodian to manage the LLC, because the LLC’s activities are either unlawful or the LLC manager or controlling members are acting illegally, fraudulently or oppressively to the other member. The right might be of particular concern where key employees or other third parties have minority interests in family businesses organized as LLCs. In family investment LLCs, which have become a common planning vehicle, might this permit an antagonistic family member to unwind the family entity?
- Distributions
The Revised LLC Act provides that unless the members of the LLC agree otherwise, any distributions to members, before the dissolution and winding up of the LLC, are to be made to members in equal shares. If the LLC is owned by family members, it is important to have an operating agreement specify the ownership and distribution percentages. If, for example, a parent made gifts of most of his or her LLC interests and distributions were still made equally by a member, that might cause an estate inclusion issue for the parent. In some instances the default law may be desirable to provide a position to argue that the LLC interests are included in the parent’s estate to obtain a basis step-up.
Martin M. Shenkman, CPA, MBA, PFS, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.
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Income tax planning for trusts has been profoundly affected by the dramatic changes the American Taxpayer Relief Act of 2012 (“ATRA”) has had on the tax system. Income tax rates are higher. The federal estate tax, which had been an issue for many clients, now affects only a super-wealthy few. These changes have significant impact on how every practitioner completing a Form 1041, or even a 1040 for clients receiving K-1s from trusts should plan. Even if your clients face a state estate tax, the cost is significantly less than the combined state and federal estate tax that they had once faced. Trusts are subjected to an income tax regime very similar to that faced by individuals, but with a special deduction for distributions of distributable net income (“DNI”). Another hallmark of trust taxation is that trust income is subject to a compressed tax rate structure so that the maximum trust income tax bracket is reached at only about $12,000 of income. The Medicare Surtax which became effective in 2013 has added to the compressed income tax burden that trusts face. The following checklist will help you in the process:
√ General Trust Planning Tips to Reduce the Surtax
Planning for the Medicare Surtax under IRC Sec. 1411 has been the “talk of the town” since it first became effective in 2013. Practitioners planning for and preparing Trust Forms 1041 must be especially alert for planning opportunities to reduce the Surtax. This is especially important if the beneficiaries might sue trustees if the trust incurs Surtax that could have been avoided.
- Reduce trust income below the threshold amount if the trust is close to the level at which the Surtax applies. This is most simply accomplished by making distributions to beneficiaries that push income out of the trust to the beneficiary via the distributable net income (“DNI”) deduction to the trust.
- Trustee fees can be used to adjust how much NII is distributed. In regular income tax world trustee fees can generally be allocated against just certain types of income included in DNI (such as interest income) if that is more highly taxed and reported that way on the K-1. Specially allocating trustee fees will also impact the amount of NII that is deemed to be distributed. If you can do this in the income tax world it should affect the NII Surtax world in a similar manner. Note that in the regular income tax world some portion of expenses must be allocated to non-taxable income, e.g. muni-bonds, and lose the deduction to that extent. After making the trustee fee allocation for general income tax purposes and determining how much of each type of income is distributed under the regular DNI rules, a deduction for trustee fees is then allowed in determining the amount of undistributed NII that is subject to the Surtax, but the trustee fees must be allocated proportionately among NII and non-NII items.
Many clients and trustees will not be comfortable simply distributing funds to beneficiaries to save income tax. Consider the use of LLCs and FLPs to hold trust distributions to provide some measure of control. Flow through entities can pass income to “beneficiaries” without the need for actual distributions like a trust.
- Common advice is to convert NII to non-NII, but trustees have a fiduciary duty to invest trust assets. Investments must conform to the Prudent Investment Act unless the legal documents permit variation, but even variation must be undertaken with caution.
- Make interest tax exempt by investing in municipal bonds and move investment assets into life insurance which is protected by a tax favored envelope, but again, being mindful of the Prudent Investor Act.
√ Grantor Charitable Lead Trust
Unlike their more popular cousins, charitable remainder trusts (“CRTs”); charitable lead trusts (“CLTs”) are taxable. Practitioners should be alert for a fundamental change in the tax status of many newly formed CLTs. With higher income tax rates and substantial recent appreciation in the stock market there should be increasing interest in the use of grantor charitable lead trusts (“CLTs”). CLTs, while generally structured as non-grantor trusts, can be structured as a grantor trust so that the donor may benefit from a current income tax charitable contribution deduction. The deduction would be the present value of the qualified annuity or unitrust interest to be paid to the charitable beneficiary. IRC Sec. 170(f)(2)(B). In the remaining years of the CLT the grantor will be taxed on all of the income of the CLT. Thus, the value of the current contribution deduction must outweigh the income taxes that will be due in those future years.
A CLT can be characterized as a grantor trust to achieve this result in the following ways:
- A reversionary interest with value greater than 5% of the value of the trust assets at the time assets are transferred to the trust is held by the grantor’s spouse, the CLT will be characterized as a grantor trust. IRC Sec. 672(e).
- The grantor has a reversionary interest with value greater than 5% of the value of the trust assets at the time assets are transferred to the trust. IRC Sec. 673.
- The grantor retains a power to substitute assets, for assets of an equivalent value, in a non-fiduciary capacity. IRC Sec. 675(4)(C).
√ Use CRTs to Defer and Perhaps Avoid the Medicare Tax
CRTs, as tax-exempt trusts, are not subject to the Medicare tax. However, when the CRT makes distributions to current non-charitable beneficiaries, e.g. the client/grantor, some portion of a distribution may be characterized as NII and subject to the Medicare tax. While the CRT itself is exempt from income tax, the annuity or unitrust distributions made to individual beneficiaries are subject to regular income tax and Medicare tax. Under the final regulations, net investment income is classified and distributed using the four existing classes into which CRT income must be divided under IRC Sec. 664. These classifications capture the historic categorization of income earned. Generally, the most costly categories of taxable income are deemed distributed first. NII would similarly be identified as a sub-component of each such class of income. The NII of the CRTs beneficiary attributable to the beneficiary’s annuity or unitrust distribution will be deemed to include an amount equal to the lesser of: (1) the total amount of distributions for the year and (2) the current and accumulated NII of the CRT. Prop. Reg. Sec. 1.1441-3(c)(2)(i). If there is more than one beneficiary the NII is apportioned among the beneficiaries based on their respective shares of the total annuity or unitrust amount paid by the trust for that year.
For example, if a client gifts appreciated property to a CRT which is subsequently sold by the CRT, there is no immediate imposition of regular income tax or Medicare tax under IRC Sec. 1411 tax on the capital gain which is NII. The full amount of the sale proceeds can be reinvested in the trust. The deferral of the recognition of NII by having made the gift to the CRT which sells the assets instead of the individual donor may effect not just a deferral but an avoidance of the Medicare tax. For example, if the gain were realized in one year by the client much of the gain could be subject to the Medicare tax. It is possible for some clients that the spreading of that gain out over many years as part of the CRT tier system may result in the realization of that NII in sufficiently small quantities that the client’s MAGI remains under the threshold amount necessary to trigger the Medicare tax in future years. This same result may reduce the bracket in which income is realized as well.
√ Divorce Considerations
Most clients remain concerned as to whether trust assets are reachable in a divorce. Whether a trust is reachable in a divorce proceeding will depend on state law, as well as on a number of trust characteristics. A “discretionary” trust gives the trustee the power to determine if, when, and how much to distribute from the trust. This can be more difficult to reach through in a divorce. If, on the other hand, a trust is deemed a “support” trust, which directs the trustee to make distributions to support the beneficiary, it may be reachable. A common support standard is Health Education Maintenance and Support, referred to by the acronym “HEMS.” Supports trusts may have to rely on a spendthrift provision for any protection from claimants. Thus, a support trust might be easier to reach in a matrimonial action. While these generalities provide useful constructs, reality is much more complex because many trusts are actually a blend of the two principals, and all of this is compounded by the differences in state law, and how the trust is administered. A court might be influenced to see a trust that makes those regular distributions of trust income as somehow being more readily available, than a trust that has not made distributions. Practitioners rendering tax planning advice that suggests distributions should be mindful of these important ancillary consequences.
√ State Tax Compliance
State income tax planning for trusts will remain a critical component of planning and as the importance of estate tax planning wanes, state tax considerations will become relatively more important. Planning the initial situs of a trust, which state laws will govern, and which state or states can tax trust income, could have a material impact on the economic effect of the trust. If a trust is formed in a less than optimal jurisdiction, it may be possible to use the process of decanting (merging or transferring an existing trust into a new trust with more desirable provisions), or other techniques, to modify existing trusts to achieve better results.
Practitioners must bear in mind that as they recommend distributions from trusts to flow out DNI to lower bracket beneficiaries, those beneficiaries may be liable for state income tax on the distributions that could exceed the income tax that the trust might pay. For example, the trust may be based in a state that does not assess income tax on the trust. A distribution may reduce the trust’s federal income tax burden, but it could subject the beneficiaries to a high incremental state income tax.
Where a trust is administered may have important implications to the application (or avoidance) of state income taxation. In a recent case a New Jersey resident created a testamentary trust. In 2006 the sole trustee resided in New York and the trust was administered outside New Jersey. The trustee filed and paid New Jersey tax on S corporation income attributable to income from New Jersey, but not on S corporation income attributable to non-New Jersey sources. The fact that the tax return showed a New Jersey address was not deemed significant by the Court. The court held that since the trust was not administered in New Jersey, the Trustee was a New York resident and therefore could only be taxed on New Jersey source income. Residuary Trust A. v. Director, 27 NJ Tax 68 (2013). Thus, in guiding clients as to state income tax compliance and tax planning practitioners need to consider not only where the trust is administered, but the potential for changing that place of administration to improve state income tax consequences.
√ Multiple Fiduciaries
The increasing complexities of trusts using various fiduciaries will complicate these decisions and planning to avoid state income tax. Some trusts may have an institutional general trustee, an individual co-trustee, a trust investment adviser, a trust protector, a person authorized to make loans for less than adequate security, the grantor or another person the right to swap assets (see below), or other mechanisms to achieve grantor trust status. A trust protector may hold broad powers to modify the terms or operations of the trust. Practitioners should be cautious in determining tax status and other filing positions to ascertain whether one or more of these fiduciaries (or “quasi-fiduciaries”) has taken actions that might affect the tax status or other attributes of the trust.
√ Swap Powers
An approach to ensure that clients die with the lowest-basis assets is to include a swap power in trust agreements. The swap power causes the trust to be a grantor trust and permits the holder, typically but not always, the grantor, to swap trust assets for assets of equivalent value, e.g., cash. If a client has made transfers to a grantor trust, he or she may be able to exchange or swap cash for appreciated assets held in the trust, thereby bringing those assets into their estate for a step-up. To make this swap power viable, consider drafting standby purchase instruments. Also endeavor to have lines of credit and other cash resources secured well in advance. This power, while interesting in theory, creates a number of practical issues. How can it be exercised? While one commentator quipped in humor that clients should be called weekly to assure that they are still well enough to exercise the power, when should it be exercised? At minimum, annual planning meetings should address this power.
√ Irrevocable Trusts Generally
Existing irrevocable trusts should be reviewed to ascertain what, if any, purpose they serve, or can be made to serve, in the new tax environment. Practitioners should not merely prepare returns for trusts because they were prepared in prior years without ascertaining whether the trust is still viable and if viable, still appropriate. If the trust no longer serves optimal planning purposes it may be feasible to merge (decant) the trust into a new trust better crafted to meet current circumstances. This can provide an efficient mechanism to salvage the trust purpose. Decanting can be accomplished in one of three ways:
- Pursuant to the terms of the trust, if the governing instrument permits a transfer of trust assets to the new trust.
- Under state statute. A growing number of states permit decanting pursuant to state statute.
- Under state common law.
Decanting may enable a trustee to extend the term of an existing trust, although generation skipping transfer tax issues must be addressed; correct scrivener errors; add a spendthrift provision to protect trust corpus from potential claims of a beneficiary’s creditors; change trustee provisions; change governing law and situs to a state that is more favorable to achieving trust objectives; convert a non-grantor trust to a grantor trust, or vice versa; or qualify a trust as a special needs trust under applicable state law if the successor trust lacked these provisions.
Caution must be exercised in decanting a trust that is GST exempt or grandfathered to avoid tainting that benefit.
√ Irrevocable Life Insurance Trusts (“ILITs”)
Many ILITs were created to hold life insurance to pay an estate tax that may no longer be relevant to the client. Repurposing existing ILITs if the insurance is no longer needed for its initial purpose, or if the trust no longer optimally serves the client’s purposes, may be productive. For, example, a trust owning insurance might be modified by any of the following approaches:
- The insurance may be cashed in and the proceeds distributed to current beneficiaries and the trust terminated.
- The insurance may be retained and the trust modified or decanted to better meet current needs.
- Many ILITs simply hold life insurance and a nominal bank account, but the trust provisions may permit a much more robust trust that can serve as a spousal lifetime access trust to receive and hold additional gifts in order to save state estate taxes or for other purposes.
√ 663(b) 65-Day Election
Under this election, an amount paid or credited to a beneficiary within the first 65 days of a tax year can be treated as if paid or credited during the estate or trust’s prior tax year. This election might facilitate shifting income to a lower bracket taxpayer, shifting income to avoid an underpayment of estimated taxes, or facilitating taking advantage of a net operating loss. The election is made by checking the required box on Form 1041 for the estate or trust. Treas. Reg. Sec. 1.663(b)-2(a). This election is generally only applicable to complex trusts. This is because simple trusts are required to distribute income annually and should generally not have the result necessary to make an election. In light of the new Medicare tax on passive net investment income of estates (and trusts) the fiduciary may wish to use flexibility in the governing instrument as to distributions, and the varying tax brackets of the estate and the various beneficiaries to make a distribution within 65 days of the close of the tax year to reduce the estate’s Medicare tax on net investment income (“NII”).
Martin M. Shenkman, CPA, MBA, PFS, AEP, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.
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- Written by: Martin M. Shenkman
Partnerships, and limited liability companies (LLCs) taxed as partnerships (both to be referred to as LPs), are ubiquitous in the planning and compliance process. The following are tips and planning ideas, generally with an estate planning flavor, that practitioners can identify when preparing or reviewing partnership tax returns. Any references to partnerships will include LLCs when taxed as partnerships. With the practical demise of the federal estate tax for most clients after the Taxpayer Relief Act of 2012 (ATRA) as a result of the $5.25 million inflation adjusted permanent exemption, planning for partnerships has changed dramatically. Partnerships have for well more than a decade been used by many clients as estate tax discount machines. The prevalence of lack of marketability and lack of control discounts have been used to reduce many estates. With this use no longer relevant to most clients, what’s left? The answer is “plenty.” There are many opportunities to repurpose existing partnerships to serve clients in the new post-ATRA tax environment.
√ Not an LP
LPs are frequently associated with creating discounts for estate planning purposes, so much so that some clients may not realize that there are other applications. The primary reason for the use of LPs has always been to limit liability risks. Practitioners should be alert to client real estate investments, home-based businesses, and other endeavors that remain held in personal name rather than in LP format. Restructuring those assets or activities to provide asset protection should remain a key focus of all planning.
√ No Form 1065
While this is a checklist for partnership income tax returns, the most important LP planning opportunities might be identified when there is in fact no Form 1065 filed. When a husband and wife own a business organized as an LP, if the requirements of a qualified joint venture (“QJV”) are met, they can avoid filing partnership income tax returns. IRC Sec. 761(f). This is typically viewed as a beneficial result as it can save the annual filing fees. In fact, that may well prove a significant detriment and not a benefit. If the business is sued and there is no Form 1065 to provide to the claimant, the income tax return reporting the results of that business will be the clients’ personal Form 1040. Having a separate tax return may suffice to protect the remainder to the client’s confidential information in a lawsuit. Similarly, if a client has a single member disregarded LLC, they may view that as a benefit as they can merely file a Schedule C or E on their personal Form 1040 instead of incurring the cost of filing a separate Form 1065. However, just like with the QJV, most clients would be advised to file the separate Form 1065 by adding a second member to the LLC so it will no longer be a disregarded entity. There are significant legal reasons for this step as well. A single member LLC will not be afforded charging order protection under most state laws, whereas an LLC with a legitimate second member will. Charging order protection may serve to severely limit the rights of a claimant to receive merely the client’s interests in profits of the LLC, and not to become a substitute member. Since the primary reason clients use LLCs is asset protection (insulating personal assets from business or investment risk) in most cases adding the second member will help achieve the client’s objectives.
√ Permanent File
If you’re preparing a Form 1065 you should have a permanent file for the LP. At minimum documents should include the partnership (LLC) certificate used to form the partnership as well as any amendments filed changing this. At minimum you should have a copy of the current (and if feasible all prior) partnership agreements (operating agreements for LLCs). Some partnerships and LLCs issue certificates, similar to stock certificates, evidencing ownership interests. Also, some partnerships and LLCs sign periodic documents, analogous to corporate minutes. These might be called consents or actions or by some other name. While CPAs tend to view all of these documents as within the purview of the attorneys, they are squarely within the responsibility of the CPA as well. You should not file an LP return before confirming the ownership interests you are reporting on the Forms K-1 are consistent with all the underlying legal documentation. If there is an inconsistency, legal counsel for the entity should resolve it. However, failing to look can exacerbate tax, legal and other problems. Other discussions in this checklist will highlight other issues to consider in looking at these documents.
√ Income Shifting
With the demise of the federal estate tax for most clients, LPs from a tax perspective may shift focus back to their historical roots of being used to shift income from higher bracket to lower bracket family members. If a parent, or other benefactor, gifts LP interests to a child (or other donee), then that donee may be able to report the income attributable to that interest on his or her return and at his or her tax rates which may be lower than the donor’s marginal tax rates. For this tax shift to succeed, capital must be a material income-producing factor in the LP. IRC §704(e)(1); Treas. Reg. §1.704-(e)(1)(ii). But the use of LPs to shift income is quite different today than it had been decades ago when this type of planning was so popular. The Kiddie Tax will result in a child paying tax at the parent’s highest tax bracket for children as old as 23. The Kiddie Tax creates a considerable restraint on shifting income to younger children, but doesn’t obviate the benefits of planning. The permanent increase in the estate tax exemption to $5 million inflation adjusted, has also changed the dynamic of LP income shifting. Most clients can now shift any amount of LP interests to young adult children no longer subject to the Kiddie Tax with no practical concern about the gift tax. This is because the $5 million permanent inflation adjusted exemption makes the gift tax irrelevant for the vast majority of clients. Years later, when a young adult child’s income grows, the child could gift the LP interests back to the parent, or perhaps to a trust to benefit the parent if advisable at that time from a Medicaid or other planning perspective. Years ago when using FLPs to shift income was a popular planning technique, the $600,000 non-inflation adjusted gift exemption had posed a significant constraint on transferring FLP interests.
√ Don’t Liquidate FLPs Without Consideration
With the practical permanent demise of the estate tax for most clients, many may request that FLPs be liquidated to save the costs of tax filings, legal fees and so forth. Before pursuing that option carefully review non-estate tax benefits of the FLP with the client. For example, if the client or the client’s heirs face any type of liability risk, the asset protection benefits may well be worth retaining the LLC. Many clients evaluate this only with respect to their concerns, which post-retirement may be negligible in their view. However, if the clients will be shifting significant wealth, or already have made substantial gifts, the FLP can be a valuable asset protection tool for heirs. Another less common consideration should also be evaluated before liquidating an FLP. If the client, or a client’s business, owns any significant life insurance, consider the possible benefits of the FLP to avoid the transfer for value rules. The transfer for value rules can result in the proceeds of a life insurance policy being subject to income tax. However, transfer of an insurance policy to a partner of the insured (or a partnership in which the insured is a partner) will not trigger the transfer for value rules. IRC Sec. 101(a)(2)(B). Be alert for opportunities to help clients restructure the partners in a partnership to include those taxpayers who may be involved in insurance transfers, such as a closely held business that no longer requires buy-out insurance, etc. The partnership involved, however, must be a bona fide entity, and not merely an entity established to effectuate the insurance transfer. If the partnership owns significant other assets, and was not formed for the purpose of facilitating the transfer of the insurance policies, it may be respected as qualifying for an exception to the transfer for value rule. PLR 200120007.
√ Annual Gifts of FLPs Over
Annual gifts of FLP interests had been a common estate planning tool. The planning, in big picture terms, was quite simple. Parents established an FLP and gifted assets, quite often marketable securities. The FLP interests were appraised, almost universally considering discounts for lack of control and lack of marketability. Then each year the parents would gift annual exclusion gifts, currently $14,000/year/donee, to each heir. This apparently common and “simple” planning step was fraught with complexity and costs. The costs of appraisals were significant, and the reality has been that in too many cases clients have shortcut the required appraisal steps. The partnership agreements (operating agreements in the case of an LLC) had to be reviewed by counsel to be certain that the requirements for a present interest gift (a prerequisite to qualifying for a gift tax an annual exclusion) are met. IRC Sec. Sec. 2503(b). The Regulations provide that a future interest may be created by the limitations contained in an instrument of transfer used in effecting the gift. Regs. Sec. 25.2503-3(a). Thus, the partnership agreement, the assignment forms used to transfer the partnership interests, or other documents may all undermine the clients sought after tax benefit. Price v. Commissioner, T.C. Memo. 2010-2. All this was compounded by the legal documentation to effectuate small dollar gifts, and the accounting work to determine the appropriate allocates each year. This type of planning in most circumstances is not really worthwhile. For most clients seeking to reduce their estate (or shift income) larger periodic gifts are more advisable. This can simplify and cut costs. If the client is financially insecure about making a larger gift the answer in many cases will be to evaluate who the donee should be. Instead of making gifts to heirs outright, which is complex in terms of recordkeeping, involves heirs in the entity, may expose entity interests to being evaluated during a divorce of heirs, etc., advise the client to make the gift instead to a spousal lifetime access trust which the other spouse and heirs can be beneficiaries of. For a single client, consider a gift to a self-settled trust formed in a state that permits this technique, with the spouse as a beneficiary of his or her own trust. Annual gifting may never be the same.
Martin M. Shenkman, CPA, MBA, PFS, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.
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