We avoided the fiscal cliff when Congress passed the American Taxpayer Relief Act of 2012 on January 1, 2013.  The exemption from estate tax is $5 million, indexed for inflation.  The lifetime exemption from gift taxes is also $5 million and fully integrated with the estate tax.  To the extent that a person uses part of their $5 million gift tax exemption during life, it reduces the estate tax exemption available at death.  The estate tax rate is 40% on estates exceeding the exemption.  The new law also makes permanent the portability of the exemption amount between spouses.  Portability allows for the surviving spouse to use the unused estate tax exemption of a deceased spouse.

These two changes, a dramatic increase in the exemption amount coupled with the ability to use a spouse’s unused exemption, have resulted in a change in estate planning techniques.  The prior estate tax regime was a use it or lose it proposition meaning that if we did not use the first spouse’s exemption amount upon the first spouse’s death, we would lose the ability to use it in the future.  The vast majority of estate plans drafted prior to the new law are referred to as A-B trusts which require the mandatory funding of a bypass trust upon the death of the first spouse.

When the first spouse died, we would take half of the assets and transfer them into the bypass trust.  This administration upon the death of the first spouse was required in order to be able use the exemption of the deceased spouse.  The administration would require us obtain a Tax ID number, set up bank accounts and transfer property into the bypass trust.  The bypass trust must be irrevocable so the surviving spouse could not change its terms.  Also, the bypass trust would have to file its own tax return each year.  The surviving spouse also must be prepared to account to the future beneficiaries of the bypass trust if requested.

Most estate planning attorneys no longer automatically include the bypass trust in their trusts.   The new law makes the portability of the exemption between spouses permanent.  We now make funding of the bypass trust optional.  I generally draft my trusts to provide that everything passes to the surviving spouse upon the death of the first spouse but that the surviving spouse has the option of disclaiming property to a disclaimer trust which would operate as a bypass trust.  Effectively, we are simply making the funding of a bypass trust optional, rather than mandatory.  One important thing to note is that the disclaimer must be made within 90 days of the date of death or the ability to fund the disclaimer trust terminates.

The majority of my clients request that I update their trusts to remove the mandatory bypass and replace with the optional disclaimer trust format.  We still use the mandatory funding of a bypass trust at times, particularly in the case of second marriage where one of the parties may have prior children.

Daniel T. Quane, Esq. is an attorney with the Family Trusts and Estates Law Group, Danville, California. Our vision brings together a team of highly experienced and distinguished family, trust and estate attorneys all of whom deliver specialized knowledge, strategic insight and tactical planning.  Since 1984 we have dedicated ourselves to this mission.  We are very proud of our attorneys and our talented support team which includes California State Bar Certified Family Law Specialists, brilliant staff attorneys, and committed and experienced Certified Paralegals and technical staff.   We practice our profession with integrity, strength and commitment to our clients.

FamilyTrustsandEstates.com

925-314-2320

Business owners are personally liable for the debts of the business or a legal judgment against the business if the business is not incorporated.  There are three primary forms of business incorporation: the C Corporation (C Corp), the S Corporation (S Corp) and the Limited Liability Company (LLC).  Incorporation of a business into one of the three above entities will limit the owner’s personal liability for the business’ debts and judgments.

Pass Through Taxation:

The C Corp entity choice results in two layers of taxation.  The C Corp is a separate taxpayer and will pay taxes on the income of the business which is the first layer of taxation.  The shareholders are then taxed on their receipt of the business’ distribution of the income to the shareholders which is the second layer of taxation.

The S Corp and LLC structures avoid the double layer of taxation and are known as “pass through” entities.  The S Corp and LLC income is not reported on the business’ tax return; rather the income passes through to the business owners and is taxed on the owners’ personal tax returns.

Differences Between S Corps and LLCs:  

Both the S Corp and LLC provide the limitation of liabilities of a separate entity while not incurring a double layer of taxation.  However, important differences between S Corps and LLCs exist which must be analyzed prior to choosing the appropriate entity form for a given business.  The primary difference between the S Corp and the LLC are detailed below.

Business Formation and Management:

The formation and management of an LLC is extremely simple.  The formation of an LLC only requires the filing of its Articles of Incorporation with the California Secretary of State.  An operating agreement should be drafted outlining the management of the LLC and the duties and rights of the business’ owners (the LLC members).

An S Corp requires Articles of Incorporation to be filed with the California Secretary of State similar to the LLC.  However, the S Corp also requires the more extensive formalities of the appointment of a board of directors, the drafting of corporate bylaws and the issuance of corporate stock.  The S Corp must also hold director and shareholder meetings, keep minutes of the meetings, and file annual reports.

Business Owners:

The owners of an S Corp (shareholders) must be U.S. citizens or permanent residents and the S Corp may not have more than 100 shareholders.  These limitations do not apply to the LLC so the LLC may be the appropriate entity choice where an owner is not a U.S. citizen or permanent resident or a large number of owners is desired.  It is also important to note that the LLC has a limited life and may end upon the death or bankruptcy of a member while the S Corp can continue for an unlimited duration.

Profit Sharing:

The members of an LLC may assign the business profits and losses disproportionately amongst the members if that is provided in the operating agreement.  The S Corp is required to allocate income and losses proportionately amongst its shareholders.  The flexibility of the LLC is especially beneficial when one owner is dedicating personal efforts toward the business while other owners may remain in a more passive role.

Self-Employment Taxes:

The earnings of both the S Corp and the LLC are taxed in their entirety to the owners whether or not the earnings are actually distributed to the owners.  Some amount of the earnings may remain in the S Corp or LLC to provide for business expansion.  The entire amount of the earnings of the LLC is subject to self-employment tax regardless of whether the earnings are distributed to the owners or retained in the business.

The S Corp owners must only pay self-employment tax on their salaries and the remaining earnings may be retained in the business or distributed to the shareholders without incurring self-employment tax.  The IRS requires the S Corp shareholders who work for the business to pay themselves “reasonable compensation” to avoid abuse of this distinction between the S Corp and the LLC.  The S Corp’s ability to avoid paying self-employment taxes on all of its income is significant given the fact that the self-employment tax rate is 15.3% (but one-half may be deducted as an expense).  This distinction from the LLC may result in the conclusion that the S Corp is the appropriate entity form for a given business.

California Taxes:

S Corps and LLCs are taxed differently at the state level.  California taxes S Corps at a 1.5% rate on net income with a minimum tax of $800 due each year.  California requires LLCs to pay an $800 franchise tax plus an additional fee on gross income over $250,000.

Real Estate Investment:

The LLC should most likely be chosen as the entity of incorporation where the purpose of the business is real estate investment.  The members of an LLC can add the amount of the mortgage to their basis in their computation of loss, a benefit not available to S Corp shareholders.

Conversion to C Corp:

The S Corp is easily converted to a C Corp with the filing of a single form with the IRS.  The conversion of the LLC to a C Corp is far more involved as all of the corporate formalities would be required to be put into place.  The ability to convert to a C Corp may be important if the business is seeking venture capital.  Most venture capital firms invest in C Corp entities rather than S Corps or LLCs.

Daniel T. Quane, Esq. is an attorney with the Doyle Golde Quane Family Trusts and Estates Law Group, Danville, California. Our vision brings together a team of highly experienced and distinguished family, trust and estate attorneys all of whom deliver specialized knowledge, strategic insight and tactical planning.  Since 1984, we have dedicated ourselves to this mission.  We are very proud of our six attorneys and our talented support team which includes California State Bar Certified Family Law Specialists, brilliant staff attorneys, and committed and experienced Certified Paralegals and technical staff.   We practice our profession with integrity, strength and commitment to our clients.

FamilyTrustsandEstates.com

925-314-2320

A transmutation is a transfer of property between spouses whereby the characterization of the property changes as a result of the transfer.

The Problem:  Either 1) estate planners in pursuit of a significant tax benefit applicable to the transfer of community property to a surviving spouse cross the line by accidentally transmuting separate property to community property upon funding a joint marital revocable living trust or 2) clients who once held a generous intention borne of marital happiness lose or forget that objective at the time of divorce.

The Impact:  Separate property is viewed as community property when the couple divorce.

The Estate Planner’s Job:  Cautiously draft revocable trusts, community property declarations and trust transfer

deeds so as to avoid accidental transmutation.

The Family Law Attorney’s Job:  Review revocable trusts, community property declarations and trust transfer deeds in order to rule in or rule out intentional or accidental transmutations.

Accidental transmutations are easy to avoid when funding a marital revocable trust.  That said, there many marital revocable trusts in place that crossed the line into transmutation of separate property to community property due to imprecise funding language.

A transmutation is a transfer of property between spouses whereby the characterization of the property changes as a result of the transfer.  Property is transmuted from community property to separate property or from separate property to community property by a writing that expressly confirms that the characterization of the property is being changed by the instrument. Cal. Fam. Code  §852(a);   Estate of MacDonald, (1990) 51 Cal.3d 262.  There are no specific words of conveyance required by the writing.  The word transmutation need not be used in the writing.  The operative concept is that of change; the writing will serve to transmute property if it clearly establishes intent to change the characterization of property.

The History of Transmutation

Before 1983, title documents, which then and now carry a presumption of accuracy, could wipe out a spouse’s separate property interest without the spouse intending to make a gift of the property.  Marriage of Lucas, (1980) 27 Cal.3d 808.  (Separate property down-payment used to acquire family residence lost to the community when title to the home taken as “joint tenants” in compliance with a realtor’s advice.)  Moreover, prior to 1984, written and oral evidence could be used to rebut title.

In other words, separate property could be lost in divorce as a consequence of trial testimony that proved that the spouse treated separate property as if it were community property by uttering words that a led a spouse to believe a transfer had occurred.

A common evidentiary theme of dissolution trials prior to January 1, 1984 involved casual conversation between spouses or third parties wherein separate property was referred to or treated by the parties as “our property.”  Prior to 1984, spouses could not be certain that clearly-titled separate property (or separate property that was mistakenly titled otherwise such as joint tenancy or co-tenancy as property frequently is titled upon the advice of realtors, title officers, bankers or financial advisors) would not be lost to an unintentional transmutation or that oral or written extrinsic evidence would not be used to rebut the presumption of title upon dissolution.

In 1983 the legislature responded to the uncertainty of the 1980 Lucas decision and to the general uncertainty suffered by spouses due to the admissibility of oral extrinsic title rebuttal evidence by enacting Cal. Code of Civ. Proc. 4800.2 (since recodified as Cal, Fam. Code 2640.)  Cal, Fam. Code §2640 confirmed the date-of-transfer value of separate property to a spouse who contributed that property to the acquisition of community property.  The legislature followed in 1984 with Cal. Code of Civ. Proc. §5110.710 et, seq. (since recodified at Cal. Fam. Code §850 et. seq.) which codified the existing  rule that spouses can transmute property between themselves but which overruled case law that permitted oral transmutation agreements and allowed extrinsic written and oral evidence of title rebuttal.

The combination of Cal. Fam. Code  §852(a) (requiring transmutations to be in the form of a written “express declaration”) and Estate of MacDonald, 261 Cal.Rptr. 653 (defining “express declaration” as a clear showing of a party’s intent to change the affected property interests) made it clear that transmutations must be the product of unambiguously intentional conduct.

The Road Just Got Slippery Again

The rules applicable to transmutation were brightened by the statutes and case law after 1983.  The Fourth District Court of Appeal told us in Marriage of Koester, (1999) 73 Cal.App.4th 1032, that, largely due to the strengthening of the transmutation rules in 1983 and 1984 as refined by subsequent case law, a person cannot “slip into a transmutation by accident.”  The Second District however shows us how that can happen through common marital estate planning documents.

Of concern lately is the risk of transmutation that arises when separate property assets are transferred into a joint revocable trust established during marriage.

Two recent Second District Court of Appeal cases provide tools that help us determine whether estate planning documents transmute separate property to community property.  In 2005, the Second District  Court of Appeal gave us an example of an estate plan that does not transmute separate property to community property, Marriage of Starkman,(2005) 129 Cal.App.4th 659, and then followed in 2008 with an example of an estate plan that does transmute separate property to community, Marriage of Holtemann (2008) 162 Cal.App.4th 1175.

That both cases come from the Second District is of tremendous import.   Had Starkman and Holtemann come from different appellate districts we would have been left with what would look like a split of authority on the issue of whether revocable estate planning documents can transmute separate property to the community.  All estate plans are somewhere between Starkman and Holtemann on the spectrum of proof of transmutation and non-transmutation.  The challenge for family law attorneys is to determine where on the spectrum our client’s estate planning documents lie and whether they lie in the zone marked transmutation.

The Reason There is a Problem

Estate planners sometimes want their cake and eat it too when transferring separate property to surviving spouses.  Characterizing the decedent spouse’s separate property as community property at the time of death may have significant tax advantages to the surviving spouse due to the “double step up” in basis applicable to community property that passes to the surviving spouse.  IRC §1014.

The fact that community property receives a full double step up in basis can be convenient if a separate property owner transmutes separate property to the community during marriage and then recovers sole ownership of that same property as beneficiary of the decedent spouse’s estate.  If the property remained separate property it would not receive a basis step up on the death of the non-owner spouse.  If the separate property is transmuted to community property during marriage and the survivor gets the property back at the death of his spouse the survivor now has a new fully stepped up basis in the property.

A fine line is approached when estate planning documents seek community property treatment of separate property assets at the time of death while simultaneously preserving the separate property nature of the asset during life for purposes of separate management and control and for the purpose of protection against loss of the asset to divorce.

The Estate Planning Process

It is quite common for married couples to prepare joint estate plans.  Married couples visit an estate planning attorney together.  Their attorney advises them on the creation of a revocable trust and related documents that provide for probate avoidance and plan for an orderly distribution of assets upon the deaths of the spouses.  Estate tax planning will vary depending on the complexity of the estate however even the most basic professionally prepared estate plan will take advantage of simple estate tax management opportunities that can significantly enhance the after-tax estates of the decedent spouses.

The Estate Planning Documents

The objective of most estate plans prepared for married couples is to transfer all assets to the surviving spouse and then distribute the assets to the children or to others upon the death of the surviving spouse.  Both separate and community property is commonly transferred to the surviving spouse.  Community property left to the surviving spouse receives a double step up in basis upon the death of the decedent spouse.

The operative documents most typically prepared in connection with a marital estate plan are the Revocable Trust, an Assignment of Assets, Trust Transfer Deeds and a Community Property Declaration.  Each of these documents must be reviewed for possible transmutation problems.

The Revocable Trust establishes the rules for management during life and distribution at death of the separate and community assets transferred to the trust by the spouses.

The General Assignment of assets is used to transfer personal property and financial accounts to the trust and sometimes to memorialize intent that real property be considered assets of the trust.  The assignment will typically transfer both separate and community property to the trustees of the revocable trust.

Real property, both separate and community is transferred to the trustees by way of Trust Transfer Deed. 

The Community Property Declaration is a statement that confirms that some or all of the marital estate is community property.  The Community Property Declaration is intended to certify that assets qualify for the double step up in basis upon the death of the first to die.  To this end, there are many estate plans out there that specifically certify that all property owned by both or either of the spouses is confirmed as community property of the married couple regardless of the state of the title before transfer to the trust or the current state of the title if the property is not conveyed to the revocable trust.  The Community Property Declaration will commonly make the wholesale statement that all property owned by both or either of the parties is community property regardless of the state of the title. This addresses the fact that community property that is left to the surviving spouse is granted a “double step-up” in basis .

Divorce Usually Changes the Intent of the Parties as to How Assets are to be Held

A problem occurs when divorce, rather than death, ends the marriage.

The courts in both cases had to determine whether the language of the respective estate planning documents transmuted property between spouses.  Transfers of property rise to the level of a transmutation only if the standards set forth in Family Code §852(a) as interpreted byEstate of McDonald, (1990) 51 Cal.3d 262, are satisfied.  Family Code §852(a) provides that:

A transmutation of real or personal property is not valid unless made in writing by an express declaration that is made, joined in, consented to, or accepted by the spouse whose interest in the property is adversely affected.

Estate of McDonald, (1990) 51 Cal.3d 262, refined the rules applied to a writing that one party alleges to be a transmutation by defining what is meant by an express declaration.  The McDonald court held that:

Under Civ. Code, § 5110.730, subd. (a),(the predecessor to Cal. Fam. Code §852) providing that a “transmutation of real or personal property is not valid unless made in writing by an express declaration that is made, joined in, consented to, or accepted by the spouse whose interest is adversely affected,” a writing signed by the adversely affected spouse is not an “express declaration” for the purposes of the statute unless it contains language which expressly states that the characterization or ownership of the property is being changed. The statute precludes reference to extrinsic evidence in the proof of transmutation. However, it does not require use of the term “transmutation” or any other particular locution.

In both recent cases the husband owned substantial premarital separate property assets that were incorporated into the joint estate plan.  The first case, Marriage of Starkman, the court found the estate planning documents prepared for the parties did  not  rise to the level of a writing that expressly states that the characterization or ownership of the property was being changed by the documents.   The second case, Marriage of Holtemann,  the court found that the estate planning documents did expressly state that the characterization or ownership of the property in question was being changed by the documents.

Starkman: Not a Transmutation

In 1997 Christopher Starkman, heir to the United Parcel Service fortune, transferred his substantial separate property estate into The Starkman Family Revocable Trust, a revocable trust that was co-settled with his wife of seven years.  The trust agreement provided that the property transferred to the trust is community property unless husband or wife as transferor identifies it as separate property.  Christopher did not so identify the property.

In 2003, Christine Starkman, Christopher’s wife, filed a petition for divorce and sought her community property share of Christopher’s separate property, claiming that the transfer to the revocable trust, which internally classified the asset as community, was a transmutation.

Christopher was expressly put on written notice by way of a letter from the attorney who drafted the estate plan that “the Trust provides that there is a presumption that all trust assets are your community property unless you clearly specify otherwise.”  Christopher still did not so designate his separate property.

The trial court found that Christopher did not state an “express declaration of transmutation” and that his transfer of separate property to the trust did not change the characterization thereof.

The take-away from the Starkman case is that once-separate assets that are classified by estate planning documents as community property are not community property absent a writing memorializing the conveyance to the trust as one that incorporates a change of characterization.  The key to the analysis of the characterization of once-separate property held by a revocable trust is a link in the chain of title that establishes a change point.  In other words, you can label separate property as community property and not effect a transmutation but if you establish a point at which the characterization changes there is a transmutation.

Holtemann:  A Transmutation

Frank and Barbara were married only three years.  During their short marriage the Holtemanns settled a joint revocable trust into which Frank transferred substantial separate property.  The trust language specifically qualified the purpose of the estate plan by stating that “this agreement is not made in contemplation of a separation or marital dissolution and is made solely for the purpose of interpreting how property shall be disposed of on the deaths of the parties.”  When Barbara filed for divorced Frank relied on the qualifying language when he argued that his separate property remained separate property regardless of the label attached to the property by the estate planning documents.

The trial court disagreed with Frank and found that the Holtemann estate plan went farther than did the Starkman estate plan in characterizing property as community property.  The Holtemann estate planning documents included a document entitled “Spousal Property Transmutation Agreement” which explained that “(h)usband agrees that the character of the property described in Exhibit A is herby transmuted from his separate property to the community property of both parties.

The Holtemann trial court found that “(a) clearer statement of a transmutation is difficult to imagine.”  Frank argued that the transmutation was or should have been conditioned such that it would be inoperative upon marital dissolution.  Although this may have been Frank’s understanding of the mechanics of the estate plan the court was not persuaded.  The court dismissed Frank’s argument that in the event of either his or Barbara’s death, the survivor would be able to use the Transmutation Agreement to claim the property as community property, thus obtaining a full step up in basis to the fair market value of the property at date of death, while at the same time denying the validity of the Transmutation Agreement as an instrument which created community property under other circumstances such as divorce or separation.

In Holtemann, at least one of the parties believed that the classification of the once-separate property as community property was borne of a purely tax-motivated estate planning purpose.  The court clearly was not interested in ignoring a clear expression of transmution, one in which the transferor acknowledged a clear point of change, in deference to a tax-motivated estate planning technique designed to obtain a double step up in basis.

Had the Holtemann marriage ended in Barbara’s death rather than Barbara’s  petition for dissolution  Frank would have recovered his once-separate property from the revocable trust albeit with a stepped-up basis.  The risk of such a clearly designed and definitive expression of community property is that divorce might interfere with such a myopic estate plan.

Ironically, although the Holtemann method of establishing certainty in acquiring a step up in basis unquestionably guarantees a double step up in basis upon the death of a spouse the Starkman method of calling separate property community property (even though it is not community property) would likely have been sufficient to obtain a double step up in basis upon the death of a spouse.

Family law attorneys are well aware of the fact that it is quite possible for separate property to accumulate a community property component during marriage whether or not there is a formal transmutation.  Therefore, a frequent theme of a decedent’s trust administration is distinguishing community property from  property that was once separate property and applying a double step up in basis to the property.  See Pereirra, Van Camp, Moore,    Marsden, etc.

Very simply stated, basis is the cost or purchase price of an asset  plus cost of improvements to the asset.  Basis is subtracted from the sales price of an asset to determine the taxable gain attributable to the sale.

The basis of the fractional share interest discount is relatively straight forward.  There is a limited market of buyers willing to purchase only a portion of an asset with the remainder of the asset owned by another party.  Additionally, even if a buyer would be willing to purchase an asset with strangers owning the remainder, the purchaser would expect a large discount.  The market value of a partial interest in property is discounted from its pro rata share of the whole property because of its reduced control over the property and the increased difficulty of sale due to a lack of willing purchasers of partial interests.

There are a number of techniques to create a fractional share interest in an asset which will result in a discounted valuation of the asset.  A very simple but effective manner is to transfer two percent of a property to a child through a quitclaim deed.  The transfer will result in the parent owning ninety-eight percent of the property which will allow a discount in the value of the property of up to twenty percent.

Alternatively, the parent and child can enter a tenancy in common agreement and waive the right to partition which will result in a greater discount, possibly up to thirty percent.  One draw-back to fractional share interest discounts is that they must be an irrevocable transfer.

Daniel T. Quane, Esq. is an attorney with the Family Trusts and Estates Law Group, Danville, California. Our vision brings together a team of highly experienced and distinguished family, trust and estate attorneys all of whom deliver specialized knowledge, strategic insight and tactical planning.  Since 1984 we have dedicated ourselves to this mission.  We are very proud of our six attorneys and our talented support team which includes California State Bar Certified Family Law Specialists, brilliant staff attorneys, and committed and experienced Certified Paralegals and technical staff.   We practice our profession with integrity, strength and commitment to our clients.

FamilyTrustsandEstates.com

925-314-2335

QPRTs are great estate planning tools for individuals and couples whose estates exceed the unified credit by $1,000,000.00 or more.  The grantors must intend their children as the beneficiaries of their estate because QPRTs should not be created to benefit other beneficiaries as less restrictive options are generally available.  The ideal QPRT grantors are over the age of fifty because the tax valuation discount on the remainder interest increases with the age of the grantor.  A vacation home can be classified as a personal residence.  The QPRT is a great instrument to transfer the value of the vacation home at a discount out of the grantor’s estate to the children.  Some individuals hesitate to enter a QPRT for their primary residence because they are afraid of giving up the security of owning their home until their death.  Additionally, clients desiring to establish QPRTs should be in relatively good health to increase the likelihood that they will live past the term of years for which they will retain the residence.

The Internal Revenue Code definition of “personal residence” must be met before a QPRT can be created.  The IRS defines the residence as a personal residence if its primary use is as a residence of the grantor when occupied by the grantor.  The residence will not be considered a personal residence where rent paying tenants or co-owners reside in the residence.  The residence will still qualify for QPRT treatment if it is vacant when the grantor is absent and its primary use is not “other than as a residence.”  A person may have up to two residences in QPRTs.  One may be the principal residence of the grantor which is determined upon all the facts and circumstances in each case.  The other residence must be used by the grantor for a minimum of fourteen days during the year or if rented at fair market value for more than 140 days the grantor must use the property for a number of days equal to ten percent of the number of days it is rented.

If the grantor is a suitable candidate to use a QPRT and has a personal residence as defined by the IRS, the next step is to draft the QPRT.  The QPRT will create two interests.  The grantor will retain an interest for a term of years during which the grantor will continue to own the residence as before the QPRT was created.  The children beneficiaries will be given the remainder interest, which will be the ownership of the residence after the term of years passes.  The gift to the children is the remainder interest, rather than the entire residence.  The value of the remainder interest is determined using Internal Revenue Code Section 7520 and will be far less than the fair market value of the residence because the children must wait until the expiration of the term of years before receiving the residence.  The gift tax is paid on the value of the remainder interest at the time of making the QPRT, rather than the fair market value of the residence.  An additional benefit of the QPRT is that all of the appreciation of the residence will also pass to the children tax-free since the gift tax is paid at the time the QPRT is created.

QPRTs can result in substantial estate tax savings but it is important to highlight their possible problems.  The number of years for which the grantor retains the residence must not be set too long because if the grantor dies before the residence transfers to the beneficiaries the entire value of the residence at the grantor’s date of death is included in the grantor’s estate.  The basis of the property will not receive a step-up when transferred to the beneficiaries so the beneficiaries may receive the property with a low basis which would result in large capital gains upon its sale.  Also, the grantors must give up the beneficial use of the residence upon its transfer to the beneficiaries at the conclusion of the term of years but may pay fair market rent in order to continue residing in the residence.  The rent paid to the children will be taxable as income to the children but this operates to transfer additional assets from the grantor’s estate at a tax rate less than the estate tax rate.

QPRTs can be excellent estate reduction tools for the appropriate clients.  They work great to reduce the taxable estate of older clients who desire to pass their estate to their children.  Vacation homes are an ideal asset to fund a QPRT because people generally like to keep the vacation home in the family and do not have to lose the security of giving away their primary residence.  However, QPRTs are not for every client as they are an irrevocable transfer and the residence will revert to the grantor’s estate if they do not survive the term of years for which they are to retain the residence.

Daniel T. Quane, Esq. is an attorney with the Family Trusts and Estates Law Group, Danville, California. Our vision brings together a team of highly experienced and distinguished family, trust and estate attorneys all of whom deliver specialized knowledge, strategic insight and tactical planning.  Since 1984 we have dedicated ourselves to this mission.  We are very proud of our six attorneys and our talented support team which includes California State Bar Certified Family Law Specialists, brilliant staff attorneys, and committed and experienced Certified Paralegals and technical staff.   We practice our profession with integrity, strength and commitment to our clients.

FamilyTrustsandEstates.com

925-314-2320

The primary estate planning benefit of a FLP is to reduce the value of assets held in a taxable estate by transferring the assets into the FLP.  The assets may receive a valuation discount for lack of marketability, lack of control, and real property can receive capital gain discounts.   The assets may receive a discount for lack of marketability because a third party will require a discount as they will not own the entire asset and are forced into a partnership with the other owners.  The assets may receive a discount for lack of control because the limited partner of a partnership does not have the ability to make partnership decisions; they only have the right to review the books.  Real property with a low tax basis may receive a built in capital gain discount because under partnership tax laws the partner is responsible for the future tax on the gain of the sale of the real property because the tax will flow through the partnership to the partner.

The above discounts can reduce the value of the assets transferred to the FLP by an estimated thirty percent.  An appraiser will need to be retained to appraise the value of the original assets and also to appraise the assets after they are transferred into the FLP.  The amount of the discount will depend upon the appraiser’s analysis of the type of assets, amount and frequency of distributions, the size of the interest, and other factors.  The appraisals are necessary to validate the discount to the IRS.

The FLP should have a legitimate business purpose in addition to the avoidance of taxes.  Asset protection by limiting liability, managing control over the assets, creating an efficient manner to manage assets, and restricting the rights of others from gaining interests in family assets are all legitimate business purposes.  The FLP partners must treat the FLP as a business.  The FLP must be validly created under state law and comply with all formalities.  The FLP must have its own bank account, tax identification number, and must file separate tax returns.  The FLP must not simply distribute all its income because businesses will generally retain some income.

The client creating the FLP must retain enough assets outside of the FLP to support their lifestyle because people do not invest all of their assets into a single business.  A personal residence should not be transferred into a FLP because businesses generally do not own residences unless they are being rented.  Also, the transfer of a personal residence into a FLP will cause the owner to lose their Internal Revenue Code Section 121 capital gain exclusion.  FLPs are an excellent estate planning tool to use upon the death of the first spouse because the assets will have received a full step-up in basis upon the first spouse’s death.

FLPs require careful planning and drafting because the Internal Revenue Service has been attacking FLPs using two arguments under Internal Revenue Code section 2036.  The FLP must be constructed so that the party transferring the assets into the FLP receives fair and adequate consideration for those assets to overcome the argument that there was an implied agreement that the decedent was able to use the property.  Also, the IRS attacks FLPs where all a person’s assets are transferred into the FLP and deems such a transaction to create a life estate.

Property taxes are another important consideration when creating a FLP.  The parent-child reassessment exclusion will not apply to the transfer into the FLP because the shares in the FLP are the transfer of a personal property interest, not a transfer of real property.  Also, the real property will be reassessed once more than fifty-one percent of the property is transferred into the FLP.  It is also important to realize that FLPs can be expensive to establish because appraisals are required and the FLP must be maintained as a business which requires annual tax returns and state partnership filings.

FLPs can be great vehicles to transfer property out of a taxable estate at a large discount which may greatly reduce or eliminate the amount of estate taxes due upon death.  It is important to remember that they need to be drafted carefully and maintained as a business in order to survive an attack by the IRS.

Daniel T. Quane, Esq. is an attorney with the Family Trusts and Estates Law Group, Danville, California. Our vision brings together a team of highly experienced and distinguished family, trust and estate attorneys all of whom deliver specialized knowledge, strategic insight and tactical planning.  Since 1984 we have dedicated ourselves to this mission.  We are very proud of our five attorneys and our talented support team which includes California State Bar Certified Family Law Specialists, brilliant staff attorneys, and committed and experienced Certified Paralegals and technical staff.   We practice our profession with integrity, strength and commitment to our clients.

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The gift tax is exclusive while the estate tax is inclusive.  To demonstrate, assume a person would like to make a taxable gift of $150,000 but is unsure of whether to make the gift during their life or upon their death.  For simplicity, assume the gift and estate tax rate is fifty percent rather than the current forty-five percent.  If the gift is made during life $100,000 would go the donee and $50,000 would be paid in gift tax.  If the gift was made upon death, $75,000 would go to the donee and $75,000 would be paid in estate taxes.

Every person is also allowed to make annual gifts up to the annual exclusion amount which will not count against the $5,000,000 gift tax exemption.  The annual exclusion is set at $13,000 for 2010 and is per donee.

A married couple is also allowed to combine their exclusions so that they may gift $26,000 per year to a child with no gift tax consequences.  Since the annual exclusion is per donee, a married couple could make annual gifts of $52,000 to a child and the child’s spouse.  Also, the payment of tuition and medical expenses of another person is not considered a transfer for gift tax purposes and is an easy way to reduce a taxable estate.

Daniel T. Quane, Esq. is an attorney with the Doyle Golde Quane Family Trusts and Estates Law Group, Danville, California. Our vision brings together a team of highly experienced and distinguished family, trust and estate attorneys all of whom deliver specialized knowledge, strategic insight and tactical planning.  Since 1984, we have dedicated ourselves to this mission.  We are very proud of our six attorneys and our talented support team which includes California State Bar Certified Family Law Specialists, brilliant staff attorneys, and committed and experienced Certified Paralegals and technical staff.   We practice our profession with integrity, strength and commitment to our clients.

FamilyTrustsandEstates.com

925-314-2335

The two most common ways for the ILIT to become the owner of a life insurance policy is for the ILIT to purchase a policy on the settlor’s life or for the settlor to gift a policy to the ILIT. The preferred method is for the ILIT to purchase the policy because if the settlor dies within three years of making a gift of the policy to the ILIT, the insurance proceeds are includable in the settlor’s estate. One common solution is to obtain a three year term policy to protect against this contingency.

An ILIT is an irrevocable trust and the settlor must be careful to not retain any incidents of ownership. This means that the settlor cannot change the beneficiaries of the trust nor change the beneficiary of the policy, borrow against cash value or participate in any decision affecting the policy. All decisions regarding the administration of the ILIT are to be made by the trustee without the settlor’s input. However, the ILIT is set up as a grantor trust which means that any income earned by the trust during the settlor’s lifetime is taxable to the settlor and must be included on the settlor’s income tax return.

The settlor should make a cash donation to the trust along with the gift of the life insurance policy. I recommend that this gift be an amount in excess of the first year’s premium payment. The trustee will need to continue to make future contributions in order for the trust to have funds sufficient to pay the premiums on the policy. These future contributions should not be in the exact amount of the premium payments and not made only when the premium payments are due. Additionally, the settlor must be careful that the payments due not include directions or notations that could be interpreted as a direction to the trustee to use these funds to pay the insurance premiums. It is important to follow these rules to avoid the IRS claiming that the trustee was merely the settlor’s agent which may lead to the proceeds of the policy being included in the settlor’s estate.

The contributions from the settlor to the ILIT are taxable gifts. Every person is allowed to make annual gifts up to the annual exclusion amount which will not count against the $5,000,000 gift tax exemption. The annual exclusion is set at $13,000 for 2011 and is per donee. However, in order for the gift to qualify for the annual exclusion it must be presently available to the beneficiary. The trustee must advise the beneficiaries of each contribution from the settlor to the ILIT and allow the beneficiary the opportunity to withdraw the contribution. The power of withdrawal is known as a Crummey power and is necessary for the contribution to qualify for the annual exclusion.

A quick listing of additional instructions to serve as the trustee of an ILIT follows below:

(1) All decisions and actions regarding the ILIT must be made by the trustee, not the settlor;

(2) When acting as trustee, make sure you make it clear you are acting in the role by identifying yourself as trustee and adding “as trustee” to your signature;

(3) Do not commingle funds of the ILIT account and your personal funds;

(4) Do not make payments for ILIT expenses from your personal funds;

(5) Keep records of all ILIT transactions and copies of all ILIT bank accounts;

(6) Use the EIN number, not your social security number, when acting on behalf of the ILIT;

(7) Maintain sufficient funds in the ILIT to pay the beneficiaries in the event they exercise their right to withdrawal; and

(8) Give notice to the beneficiaries when contributions are made to the ILIT.

The above is only a partial listing of guidelines for the trustee to follow. It is imperative that the trustee seek and receive assistance from an estate planning attorney if any questions arise.

Daniel T. Quane, Esq. is an attorney with the Family Trusts and Estates Law Group, Danville, California. Our vision brings together a team of highly experienced and distinguished family, trust and estate attorneys all of whom deliver specialized knowledge, strategic insight and tactical planning.  Since 1984 we have dedicated ourselves to this mission.  We are very proud of our six attorneys and our talented support team which includes California State Bar Certified Family Law Specialists, brilliant staff attorneys, and committed and experienced Certified Paralegals and technical staff.   We practice our profession with integrity, strength and commitment to our clients.

FamilyTrustsandEstates.com

925-314-2320

The Mechanics of 412(e)(3) Plans.

A 412(e)(3) Plan is a defined benefit plan funded with either annuities or life insurance and annuities.  The corporation purchases the life insurance and annuities and is entitled to a deduction for this payment.  The employee plan participant is not currently taxed on the receipt of the annuities and life insurance and the plan values will grow tax-deferred.  The employee plan participant will have to pay ordinary income tax once the employee begins receiving distributions from the plan upon reaching retirement age.  The retirement income to the employee is guaranteed by the annuities and life insurance and will not increase or decrease with the market.

The Benefits of 412(e)(3) Plans.

412(e)(3) Plans offer  larger tax-deductible contributions for the employer than other deferred compensation plans which increase the ability of the corporation and highly compensated employees from currently recognizing tax.  The large contributions result because the plans are premised upon the guarantees of the annuities and life insurance which have low assumed rates of return so the amount the employer is required to contribute is large. In addition to allowing for the deferral of large amounts of income, 412(e)(3) Plans are simple to administrate post set-up and an actuary is not needed for annual valuation or certification.

The Negatives of 412(e)(3) Plans.

Sound investing should focus on the growth of deferred compensation plans rather than simply the amount that can be deducted.  No net economic benefit is received if the plan allows larger amounts of income to be deferred but only at the cost of lost growth on the income deferred.  If the investment returns exceed the assumed rate of return upon which the plan was premised, the amount of retirement income will not increase.  The extra investment returns simply reduce the employer’s future contributions to the plan.  With other deferred compensation plans, such as a 401(k), the employee’s retirement benefit increases as the performance of the plan investments exceed expectations.  The 412(e)(3) Plans are locked into a set rate of return so participants will not receive the benefit of a bull market.

In addition to being conservative investment vehicles, 412(e)(3) Plans have some other negative attributes.  412(e)(3) Plans must meet with the same coverage and nondiscrimination rules that all qualified plans must meet.  412(e)(3) Plans cannot make loans and the company cannot skip a year of funding after establishing the plan. Most importantly, 412(e)(3) Plans are not appropriate deferred compensation plans for individuals with a taxable estate because the death benefit will be part of the decedent’s gross taxable estate.

The Ideal Candidate to Participate in a 412(e)(3) Plan.

The ideal candidate to participate in a 412(e)(3) plan is a small business owner approximately age 50 or older with few employees.  The business must be economically stable with consistent annual income in order to make the annual payments the plan will require.  The payments cannot be forgiven or deferred for a year in the event the business profits are not as expected.  The ideal candidate will be operating a successful small business which can benefit from the deferral of substantial amounts of income.  412(e)(3) Plans are more appropriate for people age 50 or older as the plan will require larger contributions because the annuity will be for a shorter length of time since the employee is nearer to retirement.  412(e)(3) Plans are also good plans for investors who desire a guaranteed return as they will not be affected by the stock market.

Daniel T. Quane, Esq. is an attorney with the Doyle Golde Quane Family Trusts and Estates Law Group, Danville, California. Our vision brings together a team of highly experienced and distinguished family, trust and estate attorneys all of whom deliver specialized knowledge, strategic insight and tactical planning.  Since 1984 we have dedicated ourselves to this mission.  We are very proud of our six attorneys and our talented support team which includes California State Bar Certified Family Law Specialists, brilliant staff attorneys, and committed and experienced Certified Paralegals and technical staff.   We practice our profession with integrity, strength and commitment to our clients.

FamilyTrustsandEstates.com

925-314-2320

There are three types of grantor trusts.  Grantor retained annuity trusts (GRATS), grantor retained uni trusts (GRUTS), and grantor retained income trusts (GRITS).  This article focuses on the use of GRATS in conjunction with the use of tax-free gifts to reduce the taxable estate.  A GRAT is an irrevocable trust created by the grantor for a specified time period.  The grantor pays the gift tax on the value of the remainder interest when the trust is established.  The assets are deposited into the trust and an annuity payment is made each year to the grantor.  When the trust expires the beneficiary receives the remaining assets tax-free.

A wealthy individual or couple should first determine the amount of money they will require to comfortably support their lifestyle until their death.  The assets that exceed this amount can be transferred during life to the later generations to avoid estate taxes upon their death.  A wealthy individual can make annual exclusion gifts in the amount of $13,000.00 per recipient for the year 2011 and can gift up to $5,000,000.00 using his or her lifetime gift tax exclusion with no gift tax payment.  A married couple can make annual gifts of $26,000.00 per recipient and gift up to $10,000,000.00 using their combined lifetime gift tax exclusions with no gift tax payment.

The benefit of these tax free gifts can be greatly increased by making the gifts to a grantor trust rather than directly to the individual.  The income produced by the grantor trust will be taxable to the grantor while the assets of the grantor trust will not be included in the grantor’s gross estate.  The grantor is responsible for paying the income tax on the income of the grantor trust so the payment of this tax is not included in the amount of the gift.  By paying the income tax on the grantor trust income, the grantor further reduces the value of his or her estate.  This allows the assets in the grantor trust to increase in value without the beneficiaries having to pay any tax on the income.

The $13,000.00 annual exclusion and $5,000,000.00 lifetime gift tax exclusion can allow the grantor to transfer a surprisingly large amount of money out of his or her estate through grantor trusts.  By making the annual exclusion gift to a single grantor trust annually for twenty years, it is estimated that the grantor will transfer more than $400,000.00 in inflation adjusted dollars.  A grantor will transfer an estimated $3,000,000.00 over twenty years by transferring $1,000,000.00 of their lifetime gift tax exclusion to a grantor trust.  These amounts can be greatly increased by creating separate grantor trusts for the grantor’s children and the children’s spouses, and for each grandchild.  A dynasty trust for the grantor’s descendants can also be created to transfer additional wealth from the grantor’s estate.

The above strategy can be applied to reduce the taxable estate of moderately wealthy individuals but for extremely wealthy individuals another dimension may be added to increase the amount of wealth transferred from the grantor’s estate.  The additional dimension is to use a series of rolling GRATS.  A rolling GRAT works by the grantor applying the annuity he or she receives from a GRAT and using it to establish a new GRAT.  The use of a rolling GRAT system maintains all the assets the grantor is attempting to transfer out of his or her estate in the GRAT transfer.  The use of simply a single GRAT will result in the annuity payments paid out of the GRAT being brought back into the grantor’s estate.  A system of short term rolling GRATS also protects against the chance of a good investment year being offset by a poor investment year because rolling GRATS are usually of short duration.

A system of rolling GRATS can transfer substantial assets from very wealthy estates and leave the grantors with the amount of capital they calculate necessary to live out the remainder of their lives at the lifestyle they choose.  Rolling GRATS are of short duration, as short as two years, so they offer the grantor the ability to adjust the flow of assets out of his or her estate at a rate comfortable to the grantor even in volatile markets.  The grantor can cease creating new GRATS and stop making annual gifts in order to reduce the flow of assets out of his or her estate.

A wealthy individual or couple can reduce their taxable estate by transferring assets during their lifetime to their beneficiaries using the annual gift tax exclusion and lifetime gift tax exclusion.  This transfer process is made more effective by transferring the assets to GRATS rather than directly to the individual because this allows for the beneficiaries to receive the income of the transferred assets tax-free as the grantor is responsible for payment of the income tax.  The system of rolling GRATS can be used to increase the scale of transfer resulting from the use of gifts combined with conventional GRATS where the amount of wealth to be transferred is substantial or must be accomplished in a short time period.

Daniel T. Quane, Esq. is an attorney with the Family Trusts and Estates Law Group, Danville, California. Our vision brings together a team of highly experienced and distinguished family, trust and estate attorneys all of whom deliver specialized knowledge, strategic insight and tactical planning.  Since 1984 we have dedicated ourselves to this mission.  We are very proud of our five attorneys and our talented support team which includes California State Bar Certified Family Law Specialists, brilliant staff attorneys, and committed and experienced Certified Paralegals and technical staff.   We practice our profession with integrity, strength and commitment to our clients.

FamilyTrustsandEstates.com

925-314-2320