When you head off into the backwoods it’s always good to take duct tape. You can use it to patch a tent, catch bugs, close a wound, and fix almost anything. Similar creativity can be brought to your estate planning. Standard techniques can be used in creative ways to better meet whatever issues arise. We’re not speaking of new fangled exotica that are soon to be on the IRS hit list; we are speaking of common planning techniques applied creatively (just like duct tape). Here are a few ideas:
Standard Use: Family limited partnerships (FLPs) and limited liability companies (LLCs) are often used to secure discounts for gift and estate tax purposes. You transfer real estate, securities, etc. to an LLC and give gifts of small percentages. The value of those gifts is invariably less than a pro rata percentage of the whole (e.g., 10% of an LLC owning $750,000 of real estate is worth less than $75,000), because a non-controlling interest is worth less than a pro rata amount.
Tailored Use: You invest in private equity and other deals. If you die, or wish to make gifts, the process of changing ownership of those assets is potentially costly and complex. Your private equity deal may require an opinion of counsel, general partner approval and more. If you make these types of investments using your FLP/LLC instead, you might avoid these transfer difficulties if you later make gifts, or in death, when these interests are transferred to various trusts under your will. You may not need to incur any additional costs or jump any extra hurdles if your LLC, and not the underlying private equity deals, are transferred. Caution: the accredited investor rules differ for a partnership and may have an impact when you invest. Rule 501 requires greater than $5M net worth for a partnership, in contrast to greater than $1M for an individual, to be an accredited investor.
Key: The FLP/LLC is not only for discounts, it facilitates transfers and succession of passive assets, while minimizing transfer costs.
Standard Use: Discounts – see above.
Tailored Use: The “transfer for value rule” can taint the proceeds of your life insurance policy as being subject to income tax! This would be a devastating tax result. This costly rule can apply if your insurance policy is, for example, sold. There are a limited number of exceptions in the law that have to be carefully followed to avoid this dilemma. If the purchaser of the policy is a partner with the insured (i.e., you) this adverse tax result may be avoided. You could set up an investment FLP/LLC for discount, asset protection and other purposes, and then have your insurance trust (ILIT) invest as a partner in the FLP/LLC. When the sale later occurs to your trust, the exception may apply because the trust is your partner.
Key: The FLP/LLC does not only provide discounts. It can also help you avoid the transfer for value rules, thus preventing life insurance proceeds from being subject to income tax.
1 Member LLC:
Standard Use: A limited liability company (LLC) is used to own a business or rental property so that a lawsuit against either will not reach your personal assets. If you are the only member of the LLC, the entity is ignored (disregarded) for tax purposes.
Tailored Use: Adding a few creative paragraphs in your LLC operating agreement (the document governing the operation of your LLC) can create an inexpensive and effective disability and succession plan. Name yourself as manager (the person to operate the LLC, which you were doing as a member/owner, just now its formally addressed). Include provisions governing what a manager can do. Name a successor manager in the event you are disabled or die. These few steps provide a succession plan to protect your investment in the event of your disability or death.
Key: It’s not only asset protection planning, its business succession planning.
Standard Use: A grantor retained annuity trust (GRAT) is a tax oriented trust to which you transfer assets, and receive an annuity for a set number of years, at the end of which your heirs (e.g. children) receive the assets. The benefit is a reduction in the value of the assets for gift tax purposes. A typical GRAT scenario might be a short 2-3 year GRAT funded with the most volatile securities in your portfolio, or a private equity deal you hope will balloon in value. The goal is to remove upside appreciation. However, if you are a physician worried about malpractice, perhaps a long 20 year term GRAT designed to give you an annual annuity is a better bet.
Tailored Use: With many short term GRATs much of principal is returned to you via the annuity payments back to the reach of your creditors. In a long term GRAT, the principal can be tied up in an irrevocable trust until after you retire. The annual annuity payments are reachable by a claimant, but the principal is in an irrevocable trust. You implement the same technique, and the same governing legal document, but use a completely different application. Key: It is not only about gift tax minimization, but asset protection as well.
Standard Use: Charitable lead trusts (CLTs) are a great charitable and gift planning technique. You can gift a large sum to a trust. A charity receives a periodic distribution for some number of years, say 6% of the value, paid annually for 20 years. The result is a dramatic reduction of gift tax cost on a large transfer of assets that will be received by your heirs (e.g. children) in 20 years. Great gift tax play.
Tailored Use: Spin this by setting up a separate CLT for each child and match the term of each CLT to the number of years until each child reaches retirement age, say 65.
Key: You still have a gift tax benefit, but now you have effectively given each child a retirement plan. If your heirs blow their inheritances, these funds will be preserved for their later years.
Standard Use: Prenups are done to protect your assets if your new marriage does not succeed.
Tailored Use: A prenup can also be used to supplement your asset protection planning. For example, it can mandate separate accounts and assets, or prepare married filing separate tax returns from separate data (so that each of you and your spouse have separate tax data to submit in the event of a suit or claim) even if a joint return is filed.
Key: Prenups can do more than protect assets from divorce; they can establish procedures and structure to backstop your asset protection planning.
Standard Use: A Qualified Personal Residence Trust (QPRT) is a special trust used to transfer ownership of your home to your heirs (e.g. children) at a discount from its current value. You gift your house to a QPRT and reserve the right to live in the house for a specified number of years, typically 5-10 years. After that time period the heirs own the house. Often you’ll reserve the right to continue to lease the house after that term at fair value.
Tailored Use: While QPRTs are typically used by older taxpayers to save estate tax, you might consider using a QPRT even if much younger. For example, you are considering accepting a position on a board of directors and are concerned about the potential liability. You transfer your house to a QPRT for a 25 year term, lasting into your retirement. In the event of a later suit or claim, absent a fraudulent conveyance, the house is owned by an irrevocable trust with remainder beneficiaries having an interest in the trust’s property.
Key: A QPRT can be more than just an estate plan, it can be part of your asset protection plan to protect your house.
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