By: Martin M. Shenkman, CPA, MBA, JD
By: Martin M. Shenkman, CPA, MBA, PFS, JD
1. Synopsis.
a. Planning for illiquid assets presents unique and difficult problems for clients, estates, and even the assets/business involved. Practitioners advising clients with substantial liquid assets need to identify the unique problems and provide guidance and solutions to deal with them.
b. This handout will review a broad range of issues and planning opportunities affecting illiquid assets including both pre- and post death planning. Addressing liquidity issues in buy sell agreements, governing documents, insurance planning in a creative and proactive manner can minimize the difficulties the client's estate will later face. Post-death planning includes addressing complex valuation issues, taking advantage of tax opportunities to defer estate tax payments, and in some cases reduce them. Fiduciaries will often have to take special steps to protect the trusts and estates they are responsible for as well as to protect themselves from beneficiary challenges. These include properly interpreting will and statutory provisions affecting illiquid assets such as the Prudent Investor Act, tax allocations, etc.
2. Introduction to planning for illiquid assets
a. Real estate.
i. Factors affecting liquidity.
1. Ownership entity/governing document terms.
2. Type of property.
3. Cash flow if any.
4. Governing documents impact on cash flow certainty.
5. Ability to sell.
6. and so on.
b. Art, jewelry and collectibles.
i. Distributed in kind versus sale.
ii. Time period and costs to effectuate appraisals, insurance, transport, sale, etc.
c. Business interests.
i. Buy sell agreement terms and funding.
ii. Transfer in kind to heirs/trusts or liquidate.
iii. Governing instrument.
d. Professional practices (including solo practitioners).
i. Short half-life if not marketed and transitioned quickly.
ii. Buy out or succession plan if any.
e. Concentrated stock positions.
3. Implications of illiquidity
a. Heirs.
i. Heirs living expenses.
ii. Expectations of heirs.
b. Property, casualty and other insurance issues.
i. Named insured should be updated to reflect personal representative and trusts.
ii. How long will insurance company cover vacant property.
c. Operations of a business.
i. Succession plan.
ii. Who will perform. Example, the accountant as executor of the estate of a real estate developer or physician with no succession plan in place.
d. Payment of estate taxes.
i. Cash impact.
ii. See below.
e. Other.
4. Cash flow sources to address illiquidity
a. Loans.
i. Third party loans.
1. Viability and cost.
ii. Related party loans generally.
1. Respect for tax purposes.
2. How set collateral and interest rates.
3. Opposing family members and/or heirs.
iii. Revolving loan from heir or family entity.
1. See sample loan document.
b. Business/real estate ongoing operations.
i. Impact of death of principal.
c. Key person insurance.
i. Adequacy.
ii. Impact of governing documents, e.g. buy sell agreements.
d. Insurance outside the business (e.g., ILIT).
i. Is it available to infuse liquidity to the estate.
ii. Other constraints.
iii. Different fiduciaries.
e. Sale of assets.
i. Can assets be sold.
ii. Price at which sale can be realized. Perception of many buyers that estates often must sell at distressed prices.
iii. Time period and costs to sell.
iv. Impact of probate issues.
5. Succession Planning for Illiquid assets
a. Buy sell agreements.
i. Lauder. Estate of Joseph H. Lauder, T.C. Memo 1992-736.
1. Estate sold stock for $4,000/share. IRS claimed value was $13,000/share. The estate used a formula valuation/price. The IRS claimed the value was not reasonable, and that there was no justification for it since no arm's length bargain for using a book value formula. The IRS stated it was a significant undervaluation. The IRS argued that the value was much greater at the signing and that the advisers never tried to ascertain the FMV of the stock. There was no professional analysis. Then the IRS maintained that the difference was a gift from the estate to the shareholders. Taxpayer's counsel argued that if there was a gift, that it would qualify for the marital deduction to the extent it inured to the surviving spouse.
2. The children sold some shares to pay estate tax. Why did a 95 year old woman die with so many assets? She really didn't it was an $8 billion business so most of the estate value was previously transferred. They only paid tax of $550 million.
3. Lessons from the Lauder case include:
a. Importance of a qualified full time professional appraisal.
b. Incorporate appraiser's methodology into the documentation.
c. Enforce the terms of the agreement pre-death. The more times the formula has been used prior to death the more credible that approach will be at death.
d. Arm's length bargaining, with different counsel, is important. Document/corroborate that different "sides" (e.g., parents versus children, kids in the business versus those not in the business), etc. You want the appearance and reality of arm's length bargaining.
e. It is essential to show a professional attempt to find FMV. In Lauder they taxpayer's did not use a modicum of effort to do this.
ii. Estate of Marlin Rudolph v. U.S., U.S. D.C. So. Dis. Indiana, No. 91-151-C, February 5, 1993.
1. Facts. The brothers were in the asphalt and concrete business. Timing is critical to the ultimate determination of this case. When the buy sell was drafted the attorney documented the purposes of it. These included: Continuity - keep the business in the family; Income for decedent/shareholder's surviving spouse; separate spouse from the business at the time of the death from the shareholder; and finally the goal of obtaining bid-bonds. If you want to bid on a governmental project you need bonds to prove you can complete the project. You need to show corporate responsibility. The taxpayers used the corporate buy sell agreement to help corroborate their responsibility and ability to complete a job they started. The agreement was included in the packages for the bid-bond applications. This was an important independent use of the appraisal that affected the final determination of this case.
2. Discounts. Lack of marketability. Tough times. This case occurred during the oil crisis in the 1980s. Why would asphalt be in tough shape? Because asphalt is made from oil products and supplies were difficult to obtain. A discount for "additional competition" was taken. How can you prove to the IRS that there is new, additional or different competition? Take the yellow pages and look by year. Evaluate the map of the area code.
3. The estate won the valuation argument because it did not discuss tax savings when the buy sell price was set. The only documented discussions were economic related. The price was set before discovery. Both parties had cancer and the price was negotiated. There was no imminent danger to the business because they each were able to have life insurance. The shareholders were healthy when the buy out price was set. This demonstrated that it was not intended as an estate tax valuation ploy. The predicted sales slump in their valuation analysis actually occurred (hindsight).
4. Note that the life insurance payable to the corporation was factored into the sales price under the buy sell agreement. No matter how this is done, it must be addressed.
5. It was not certain whether the formula used self-adjusted for changes in economic conditions but it appears that it may have.
6. Lessons from the case: The facts governing discounts may apply during the current economic turmoil. Discount arguments may apply today. Be careful to periodically update all buy sell valuations and agreements.
7. The following factors helped support the taxpayer victory in this case: The agreement was binding during life or death. It was not testamentary in nature. Comparable terms and conditions. This is the tough part of many buy sell agreements. How do you find a comparable paving company? The IRS and courts will always look at comparability. IRS is aware that a few accounting tricks here or there can manipulate result. You therefore want advisers who have worked with similar companies. The court measured reasonableness of the formula used. The date of signing is the date that is important. Practitioners need to do a better job documenting the facts at the date of the signing. How was the state of the corporation, the economy and the industry at the date of signing?
8. Other lessons to glean from this case include: There were two deaths within a short time. Consider simultaneous deaths. Give buy sells the importance and urgency of wills. They should be kept current and revisited frequently. "Very few" buy sells address multiple events. Time is of the essence in funding buy sell agreements.
iii. PLR 9315005.
1. Facts: Father and brother-in-law owned business 50/50. Father, son and brother-in-law entered into a buy sell agreement. If brother-in-law died son was required to buy as much as possible with proceeds of life insurance he purchased on the life of the brother in law. If the proceeds were insufficient then son had an option to buy the rest of the stock, but if he did not the corporation had to buy it. Brother-in-law committed suicide during the contestable period for the insurance. So no funds (other than return of premium) so son purchased only three shares of stock. The estate lowered the price after the initial purchase and the corporation purchased the shares at a bargain price, and son purchased the balance of the shares.
2. IRS said by not exercising the corporation's right to redeem the father indirectly, because he controlled the corporation, made a taxable gift to the son. In other words because father did not exercise option there was a gift.
3. Lessons to learn from this PLR. Be wary of unexercised options. Inaction (i.e., not exercising options) can create a gift. Never draft a buy sell to base the obligation to buy on the amount of life insurance someone owns because that insurance may not be there (e.g., failure to pay premiums, suicide, false application etc.). There a many reasons the insurance might fail. The buy sell agreement should provide a safety valve to pay over time in case the amount of life insurance is insufficient (e.g., installment provision).
iv. Estate of Gordon B. McLendon v. Comm'r, T.C. Memo. 1993-459, Sept. 30, 1993.
1. This case involved a "big" name in radio broadcasting who started to purchase radio stations. Then he purchased chain of radio stations, then television stations. Many medical problems developed. Cancer in 1985. This was followed by an apparent suicide attempt at the end if 1985, etc.
2. Buy sell provided that son is manager of the FLPs on his death or disability. The taxpayer set up private annuity to purchase business interests. The children were to buy his FLP interests for $250,000 plus income for life for their interest in the business.
3. Background on Private annuities. Nothing is included in the parent/seller's estate since there is no transmission of wealth on death because the private annuity payment ends on death. The use of the private annuity technique in the correct circumstances is an effective tool. You use to be able to spread out gain over lifetime but cannot do this any longer. So now sales are structured to grantor trusts. However, if you have an asset with a high basis (e.g. assets inherited from deceased first spouse) you can do a private annuity. If party is ill but not in imminent danger of dying you can use IRS tables and in effect turn the tables against the IRS. There is a rebuttable presumption if you survive for 18 months after you sign the agreement that you would have not had a fifty percent or greater likelihood of dying within a year.
4. Obtain a physician letter stating likelihood of surviving two years (not 18 months). Another clever approach is to apply for life insurance. If you get approved it will demonstrate survivability beyond one year period. There are also life expectancy reporting companies you can hire to perform an analysis. If two year survival is likely but client is in poor health private annuities make sense.
5. In this case Mr. McClendon was "circling the drain." Therefore, the IRS argued that the difference between what was paid and what should have been paid was a gift. Gift within one year was likely. Court held Mr. McClendon's actual life expectancy, not the 7520 tables, had to be used since there was a 50% or greater probability that he would die within one year.
6. A savings clauses may be void as against public policy. Some practitioners puts these in his private annuities anyhow, others avoid them intentionally in this context.
7. Lessons from this case include: Death bed private annuities are problematic. See Rev. Rul. 96-3 and 96-12. Poor health, but likely to live more than 2 years is viable. McClendon wanted to have his cake and eat it too. Economic control and benefit of assets inside FLP increased in value. He could have removed it from his estate but he retained controls over it causing estate tax inclusion. You cannot base annuity payments solely on the income of the property transferred or the IRS will argue that this was a retained income interest.
v. PLR 9349002.
1. If the corporation owns an insurance policy and you give the insured the right to buy the policy back, if the insured retains the option to buy the policy back, this is an incident of ownership over as policy on the insured's own life.
2. The woman who ran the corporation had an inactive right to buy back the policy on her own life. Provisions in the buy sell agreement provided that if certain things happened she would have the right to buy the policy back. At the time of her death these conditions were not met, so the right was inactive. Still, the IRS attempted to include the policy in her estate in its entirety.
3. Lesson. Any meaningful chance of insured buying policy back could trigger an IRS attack.
vi. PLR 9347016.
1. The corporation in this Ruling owned a life insurance policy on all three of its shareholders. They wanted to implement a cross purchase buy sell. The sons paid their father the amount equal to policies cash value. Policy on dad's life was the transferred to the sons as co-owners. There was a co-ownership is a problem. If two sons are co-owners of policy and may become co-owners with a divorced spouse, or co-owners with children. This is a complicated and unwieldy situation. You probably never want co-ownership of a life insurance contract.
2. Using the cash value of the policy as the measurement of the value of property was not adequate. Difference between cash value and real value of the policies is a gift. The real value of life insurance policy is a very difficult question today in light of secondary markets, etc. Certainly the minimum value is likely to be argued to be the interpolated terminal reserve plus unearned premium. Eventually the IRS will look at life settlement values for policies since there is a market for life insurance. Thus, the value of many life insurance policies will be found to be greater than the interpolated terminal reserve plus unamortized premium. At this point the IRS has not taken this position. It may.
3. The transfer for value rules were not triggered only because of a safe harbor. If partners, even if not transferred inside the partnership, so long as transferred to a partner or the partnership the safe harbor applies. However, don't assume that you can form a partnership for no reason other than to avoid the transfer for value rules as its only purpose and win. If the partnership has no valid business purpose the anti-abuse regulations will cause the disregard of the partnership for this purpose. What if the parties each purchase an interest in a public partnership (e.g., co-shareholders purchase interests in public limited partnership)? This sounds like an IRC Section 101 safe-harbor, but it is not the intent of the law and the conclusion is not certain.
vii. Estate of George C. Blount.
1. This case involved IRC Section 2703. October 8, 1990 is a key date for buy sell agreements. From this date onward, if a buy sell does not meet the requirements of Chapter 14, the IRS will disregard the terms and conditions that depress the value if 2703 applies (i.e., is violated). These restrictions will be ignored and IRS and courts will then be free to determine a value even if the parties are bound by the terms of the now disregarded (for tax purposes) buy sell agreement.
2. Facts: Buy sell required about $7.6 million but did not have the cash to affect this purchase. The taxpayer drew up his own buy sell agreement that was a page long. He considered the amount of cash and life insurance and changed the price to $4 million. He did not add lifetime restrictions because he did not anticipate living that long. One of the shareholders' was an ESOP and taxpayer did not even discuss with them his unilateral change. The taxpayer argued that the proceeds of the life insurance should be offset for valuation purposes by the obligation to pay for the shares. In Blount, the $4 million obligation to pay the decedent/shareholder's estate should offset the $3 million life insurance. Lower court said that the $3 million of life insurance is a non-operating asset so that the company value was the $4 million value plus a dollar for dollar increase for the life insurance of $3 million.
3. Here are the approximate numbers: $6,750,000 +3,146,134=9,896,134. Problem. The stock is according to the above calculation worth about $10 million. The estate tax was about $5 million at a 50% tax rate, on the estate's interest in the stock. However, the estate was only paid about $4 million. The tax exceeded amount received by the estate!
4. The agreement must be comparable in terms of price so value was $6.7 million. 11th circuit reversed and said you don't have to add the insurance proceeds. Is the 11th circuit right?
5. Court held that: Decedent's unilateral ability to change the agreement alone invoked the IRC 2703 provisions. The taxpayer modified a pre 1990 grandfathered agreement by substantially modifying it, so IRC Section 2703 rules now apply. What is a substantial modification? When you change value, quality or timing of rights. Taxpayer in Blount changed all of these. The buy sell agreement in Blount was not comparable to other agreements.
6. Lessons to learn from Blount: IRC Sec. 2703 applies to buy sells, options, to almost anything you put in writing to depress the purchase price if changed after October 1990. The agreement must be reasonable with a determinable price at the time it is signed. The estate must be bound to sell under the buy sell agreement. The buy sell arrangement cannot be a device to transfer the stock at a depressed price. It cannot be a testamentary device to transfer wealth from parent to child, etc. It cannot be a substitute for a will. The buy sell pricing must represent a bona fide arm's length business agreement. A lifetime price cannot be higher than the death-time price.
7. Remember that a higher level of scrutiny applies to all of these points if the parties to the buy sell are related. There must be a bona fide business agreement at arm's length but closer scrutiny is assured with related parties. The terms of the agreement must be comparable to similar businesses. Can you demonstrate that non-related parties would have entered into a similar agreement? It cannot be a d device to transfer the interests at a reduced value.
8. Problem or warning signs include: The client is old or in poor health; there were no negotiations of terms with independent lawyers; the provisions of buy sell agreement were not consistently enforced, e.g., different results during lifetime than at death-time; the client won't obtain professional advice from a full time professional appraiser in setting a valuation formula. If significant assets, such as life insurance, are excluded from the formula, the buy sell is less credible. If there is no periodic review of the terms of the agreement, the terms will be suspect. (e.g., 8-10 years go buy since buy sell last updated or reviewed). If the transfers were really based on family relationships instead of business relationships the agreement will be more suspect.
b. Charitable bail out.
i. Gift to CRT so gain is partially sheltered and contribution deduction received pre-death.
ii. Issue 2511(c).
c. Insurance arrangements.
i. Life insurance generally.
ii. Buy sell.
iii. Key person.
6. Estate Tax Considerations of illiquid assets
a. Carry over basis considerations.
i. Wills should also have express language authorizing the executor to allocate the $1.3 million general basis adjustment and the additional $3 million spousal basis adjustment. This power perhaps should be exercised by an independent person, not a beneficiary who would benefit. This is far from a simple matter to address as the possibilities are endless.
ii. What is the expected holding period for the property? If property, such as a family cottage, is intended to remain for generations in the family it is less in need of an allocation to increase basis than are other assets which are more likely to be sold.
iii. Are other avenues to avoid, defer or minimize the potential future capital gains tax available and how does their availability compare to other assets in the estate if the maximum basis adjustment has to be rationed to the various assets?
iv. CRT Example: I the estate holds raw land that is likely to be donated to the local church for an expansion project the basis adjustment is less important as compared to other assets if a charitable remainder trust could be used.
v. 1031 Exchange Example: If the estate owns a shopping center and rather than sell it a tax deferred Code Section 1031 exchange is a likely possibility, then the allocation of basis to the shopping center may be less advantageous than an allocation to other assets.
vi. Principal Residence: If the decedent's principal residence can be sold and exclude gain under the home sale exclusion rules then to the extent that that exclusion
i. Distributed in kind versus sale.
ii. Time period and costs to effectuate appraisals, insurance, transport, sale, etc.
i. Buy sell agreement terms and funding.
ii. Transfer in kind to heirs/trusts or liquidate.
iii. Governing instrument.
i. Short half-life if not marketed and transitioned quickly.
ii. Buy out or succession plan if any.
e. Concentrated stock positions.
i. Heirs living expenses.
ii. Expectations of heirs.
i. Named insured should be updated to reflect personal representative and trusts.
ii. How long will insurance company cover vacant property.
i. Succession plan.
ii. Who will perform. Example, the accountant as executor of the estate of a real estate developer or physician with no succession plan in place.
i. Cash impact.
ii. See below.
i. Third party loans.
1. Viability and cost.
ii. Related party loans generally.
1. Respect for tax purposes.
2. How set collateral and interest rates.
3. Opposing family members and/or heirs.
iii. Revolving loan from heir or family entity.
1. See sample loan document.
i. Impact of death of principal.
i. Adequacy.
ii. Impact of governing documents, e.g. buy sell agreements.
i. Is it available to infuse liquidity to the estate.
ii. Other constraints.
iii. Different fiduciaries.
i. Can assets be sold.
ii. Price at which sale can be realized. Perception of many buyers that estates often must sell at distressed prices.
iii. Time period and costs to sell.
iv. Impact of probate issues.
i. Lauder. Estate of Joseph H. Lauder, T.C. Memo 1992-736.
1. Estate sold stock for $4,000/share. IRS claimed value was $13,000/share. The estate used a formula valuation/price. The IRS claimed the value was not reasonable, and that there was no justification for it since no arm's length bargain for using a book value formula. The IRS stated it was a significant undervaluation. The IRS argued that the value was much greater at the signing and that the advisers never tried to ascertain the FMV of the stock. There was no professional analysis. Then the IRS maintained that the difference was a gift from the estate to the shareholders. Taxpayer's counsel argued that if there was a gift, that it would qualify for the marital deduction to the extent it inured to the surviving spouse.
2. The children sold some shares to pay estate tax. Why did a 95 year old woman die with so many assets? She really didn't it was an $8 billion business so most of the estate value was previously transferred. They only paid tax of $550 million.
3. Lessons from the Lauder case include:
a. Importance of a qualified full time professional appraisal.
b. Incorporate appraiser's methodology into the documentation.
c. Enforce the terms of the agreement pre-death. The more times the formula has been used prior to death the more credible that approach will be at death.
d. Arm's length bargaining, with different counsel, is important. Document/corroborate that different "sides" (e.g., parents versus children, kids in the business versus those not in the business), etc. You want the appearance and reality of arm's length bargaining.
e. It is essential to show a professional attempt to find FMV. In Lauder they taxpayer's did not use a modicum of effort to do this.
ii. Estate of Marlin Rudolph v. U.S., U.S. D.C. So. Dis. Indiana, No. 91-151-C, February 5, 1993.
1. Facts. The brothers were in the asphalt and concrete business. Timing is critical to the ultimate determination of this case. When the buy sell was drafted the attorney documented the purposes of it. These included: Continuity - keep the business in the family; Income for decedent/shareholder's surviving spouse; separate spouse from the business at the time of the death from the shareholder; and finally the goal of obtaining bid-bonds. If you want to bid on a governmental project you need bonds to prove you can complete the project. You need to show corporate responsibility. The taxpayers used the corporate buy sell agreement to help corroborate their responsibility and ability to complete a job they started. The agreement was included in the packages for the bid-bond applications. This was an important independent use of the appraisal that affected the final determination of this case.
2. Discounts. Lack of marketability. Tough times. This case occurred during the oil crisis in the 1980s. Why would asphalt be in tough shape? Because asphalt is made from oil products and supplies were difficult to obtain. A discount for "additional competition" was taken. How can you prove to the IRS that there is new, additional or different competition? Take the yellow pages and look by year. Evaluate the map of the area code.
3. The estate won the valuation argument because it did not discuss tax savings when the buy sell price was set. The only documented discussions were economic related. The price was set before discovery. Both parties had cancer and the price was negotiated. There was no imminent danger to the business because they each were able to have life insurance. The shareholders were healthy when the buy out price was set. This demonstrated that it was not intended as an estate tax valuation ploy. The predicted sales slump in their valuation analysis actually occurred (hindsight).
4. Note that the life insurance payable to the corporation was factored into the sales price under the buy sell agreement. No matter how this is done, it must be addressed.
5. It was not certain whether the formula used self-adjusted for changes in economic conditions but it appears that it may have.
6. Lessons from the case: The facts governing discounts may apply during the current economic turmoil. Discount arguments may apply today. Be careful to periodically update all buy sell valuations and agreements.
7. The following factors helped support the taxpayer victory in this case: The agreement was binding during life or death. It was not testamentary in nature. Comparable terms and conditions. This is the tough part of many buy sell agreements. How do you find a comparable paving company? The IRS and courts will always look at comparability. IRS is aware that a few accounting tricks here or there can manipulate result. You therefore want advisers who have worked with similar companies. The court measured reasonableness of the formula used. The date of signing is the date that is important. Practitioners need to do a better job documenting the facts at the date of the signing. How was the state of the corporation, the economy and the industry at the date of signing?
8. Other lessons to glean from this case include: There were two deaths within a short time. Consider simultaneous deaths. Give buy sells the importance and urgency of wills. They should be kept current and revisited frequently. "Very few" buy sells address multiple events. Time is of the essence in funding buy sell agreements.
iii. PLR 9315005.
1. Facts: Father and brother-in-law owned business 50/50. Father, son and brother-in-law entered into a buy sell agreement. If brother-in-law died son was required to buy as much as possible with proceeds of life insurance he purchased on the life of the brother in law. If the proceeds were insufficient then son had an option to buy the rest of the stock, but if he did not the corporation had to buy it. Brother-in-law committed suicide during the contestable period for the insurance. So no funds (other than return of premium) so son purchased only three shares of stock. The estate lowered the price after the initial purchase and the corporation purchased the shares at a bargain price, and son purchased the balance of the shares.
2. IRS said by not exercising the corporation's right to redeem the father indirectly, because he controlled the corporation, made a taxable gift to the son. In other words because father did not exercise option there was a gift.
3. Lessons to learn from this PLR. Be wary of unexercised options. Inaction (i.e., not exercising options) can create a gift. Never draft a buy sell to base the obligation to buy on the amount of life insurance someone owns because that insurance may not be there (e.g., failure to pay premiums, suicide, false application etc.). There a many reasons the insurance might fail. The buy sell agreement should provide a safety valve to pay over time in case the amount of life insurance is insufficient (e.g., installment provision).
iv. Estate of Gordon B. McLendon v. Comm'r, T.C. Memo. 1993-459, Sept. 30, 1993.
1. This case involved a "big" name in radio broadcasting who started to purchase radio stations. Then he purchased chain of radio stations, then television stations. Many medical problems developed. Cancer in 1985. This was followed by an apparent suicide attempt at the end if 1985, etc.
2. Buy sell provided that son is manager of the FLPs on his death or disability. The taxpayer set up private annuity to purchase business interests. The children were to buy his FLP interests for $250,000 plus income for life for their interest in the business.
3. Background on Private annuities. Nothing is included in the parent/seller's estate since there is no transmission of wealth on death because the private annuity payment ends on death. The use of the private annuity technique in the correct circumstances is an effective tool. You use to be able to spread out gain over lifetime but cannot do this any longer. So now sales are structured to grantor trusts. However, if you have an asset with a high basis (e.g. assets inherited from deceased first spouse) you can do a private annuity. If party is ill but not in imminent danger of dying you can use IRS tables and in effect turn the tables against the IRS. There is a rebuttable presumption if you survive for 18 months after you sign the agreement that you would have not had a fifty percent or greater likelihood of dying within a year.
4. Obtain a physician letter stating likelihood of surviving two years (not 18 months). Another clever approach is to apply for life insurance. If you get approved it will demonstrate survivability beyond one year period. There are also life expectancy reporting companies you can hire to perform an analysis. If two year survival is likely but client is in poor health private annuities make sense.
5. In this case Mr. McClendon was "circling the drain." Therefore, the IRS argued that the difference between what was paid and what should have been paid was a gift. Gift within one year was likely. Court held Mr. McClendon's actual life expectancy, not the 7520 tables, had to be used since there was a 50% or greater probability that he would die within one year.
6. A savings clauses may be void as against public policy. Some practitioners puts these in his private annuities anyhow, others avoid them intentionally in this context.
7. Lessons from this case include: Death bed private annuities are problematic. See Rev. Rul. 96-3 and 96-12. Poor health, but likely to live more than 2 years is viable. McClendon wanted to have his cake and eat it too. Economic control and benefit of assets inside FLP increased in value. He could have removed it from his estate but he retained controls over it causing estate tax inclusion. You cannot base annuity payments solely on the income of the property transferred or the IRS will argue that this was a retained income interest.
v. PLR 9349002.
1. If the corporation owns an insurance policy and you give the insured the right to buy the policy back, if the insured retains the option to buy the policy back, this is an incident of ownership over as policy on the insured's own life.
2. The woman who ran the corporation had an inactive right to buy back the policy on her own life. Provisions in the buy sell agreement provided that if certain things happened she would have the right to buy the policy back. At the time of her death these conditions were not met, so the right was inactive. Still, the IRS attempted to include the policy in her estate in its entirety.
3. Lesson. Any meaningful chance of insured buying policy back could trigger an IRS attack.
vi. PLR 9347016.
1. The corporation in this Ruling owned a life insurance policy on all three of its shareholders. They wanted to implement a cross purchase buy sell. The sons paid their father the amount equal to policies cash value. Policy on dad's life was the transferred to the sons as co-owners. There was a co-ownership is a problem. If two sons are co-owners of policy and may become co-owners with a divorced spouse, or co-owners with children. This is a complicated and unwieldy situation. You probably never want co-ownership of a life insurance contract.
2. Using the cash value of the policy as the measurement of the value of property was not adequate. Difference between cash value and real value of the policies is a gift. The real value of life insurance policy is a very difficult question today in light of secondary markets, etc. Certainly the minimum value is likely to be argued to be the interpolated terminal reserve plus unearned premium. Eventually the IRS will look at life settlement values for policies since there is a market for life insurance. Thus, the value of many life insurance policies will be found to be greater than the interpolated terminal reserve plus unamortized premium. At this point the IRS has not taken this position. It may.
3. The transfer for value rules were not triggered only because of a safe harbor. If partners, even if not transferred inside the partnership, so long as transferred to a partner or the partnership the safe harbor applies. However, don't assume that you can form a partnership for no reason other than to avoid the transfer for value rules as its only purpose and win. If the partnership has no valid business purpose the anti-abuse regulations will cause the disregard of the partnership for this purpose. What if the parties each purchase an interest in a public partnership (e.g., co-shareholders purchase interests in public limited partnership)? This sounds like an IRC Section 101 safe-harbor, but it is not the intent of the law and the conclusion is not certain.
vii. Estate of George C. Blount.
1. This case involved IRC Section 2703. October 8, 1990 is a key date for buy sell agreements. From this date onward, if a buy sell does not meet the requirements of Chapter 14, the IRS will disregard the terms and conditions that depress the value if 2703 applies (i.e., is violated). These restrictions will be ignored and IRS and courts will then be free to determine a value even if the parties are bound by the terms of the now disregarded (for tax purposes) buy sell agreement.
2. Facts: Buy sell required about $7.6 million but did not have the cash to affect this purchase. The taxpayer drew up his own buy sell agreement that was a page long. He considered the amount of cash and life insurance and changed the price to $4 million. He did not add lifetime restrictions because he did not anticipate living that long. One of the shareholders' was an ESOP and taxpayer did not even discuss with them his unilateral change. The taxpayer argued that the proceeds of the life insurance should be offset for valuation purposes by the obligation to pay for the shares. In Blount, the $4 million obligation to pay the decedent/shareholder's estate should offset the $3 million life insurance. Lower court said that the $3 million of life insurance is a non-operating asset so that the company value was the $4 million value plus a dollar for dollar increase for the life insurance of $3 million.
3. Here are the approximate numbers: $6,750,000 +3,146,134=9,896,134. Problem. The stock is according to the above calculation worth about $10 million. The estate tax was about $5 million at a 50% tax rate, on the estate's interest in the stock. However, the estate was only paid about $4 million. The tax exceeded amount received by the estate!
4. The agreement must be comparable in terms of price so value was $6.7 million. 11th circuit reversed and said you don't have to add the insurance proceeds. Is the 11th circuit right?
5. Court held that: Decedent's unilateral ability to change the agreement alone invoked the IRC 2703 provisions. The taxpayer modified a pre 1990 grandfathered agreement by substantially modifying it, so IRC Section 2703 rules now apply. What is a substantial modification? When you change value, quality or timing of rights. Taxpayer in Blount changed all of these. The buy sell agreement in Blount was not comparable to other agreements.
6. Lessons to learn from Blount: IRC Sec. 2703 applies to buy sells, options, to almost anything you put in writing to depress the purchase price if changed after October 1990. The agreement must be reasonable with a determinable price at the time it is signed. The estate must be bound to sell under the buy sell agreement. The buy sell arrangement cannot be a device to transfer the stock at a depressed price. It cannot be a testamentary device to transfer wealth from parent to child, etc. It cannot be a substitute for a will. The buy sell pricing must represent a bona fide arm's length business agreement. A lifetime price cannot be higher than the death-time price.
7. Remember that a higher level of scrutiny applies to all of these points if the parties to the buy sell are related. There must be a bona fide business agreement at arm's length but closer scrutiny is assured with related parties. The terms of the agreement must be comparable to similar businesses. Can you demonstrate that non-related parties would have entered into a similar agreement? It cannot be a d device to transfer the interests at a reduced value.
8. Problem or warning signs include: The client is old or in poor health; there were no negotiations of terms with independent lawyers; the provisions of buy sell agreement were not consistently enforced, e.g., different results during lifetime than at death-time; the client won't obtain professional advice from a full time professional appraiser in setting a valuation formula. If significant assets, such as life insurance, are excluded from the formula, the buy sell is less credible. If there is no periodic review of the terms of the agreement, the terms will be suspect. (e.g., 8-10 years go buy since buy sell last updated or reviewed). If the transfers were really based on family relationships instead of business relationships the agreement will be more suspect.
b. Charitable bail out.
i. Gift to CRT so gain is partially sheltered and contribution deduction received pre-death.
ii. Issue 2511(c).
c. Insurance arrangements.
i. Life insurance generally.
ii. Buy sell.
iii. Key person.
6. Estate Tax Considerations of illiquid assets
a. Carry over basis considerations.
i. Wills should also have express language authorizing the executor to allocate the $1.3 million general basis adjustment and the additional $3 million spousal basis adjustment. This power perhaps should be exercised by an independent person, not a beneficiary who would benefit. This is far from a simple matter to address as the possibilities are endless.
ii. What is the expected holding period for the property? If property, such as a family cottage, is intended to remain for generations in the family it is less in need of an allocation to increase basis than are other assets which are more likely to be sold.
iii. Are other avenues to avoid, defer or minimize the potential future capital gains tax available and how does their availability compare to other assets in the estate if the maximum basis adjustment has to be rationed to the various assets?
iv. CRT Example: I the estate holds raw land that is likely to be donated to the local church for an expansion project the basis adjustment is less important as compared to other assets if a charitable remainder trust could be used.
v. 1031 Exchange Example: If the estate owns a shopping center and rather than sell it a tax deferred Code Section 1031 exchange is a likely possibility, then the allocation of basis to the shopping center may be less advantageous than an allocation to other assets.
vi. Principal Residence: If the decedent's principal residence can be sold and exclude gain under the home sale exclusion rules then to the extent that that exclusion
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