Does Your Estate Plan Fall Prey To 3 Big Tax Issues? (2024)

In a recent email exchange with a colleague, Richard (Dick”) Oshins, Esq. who practices in Las Vegas, Nevada, Dick identified what he thinks are three of the more sinister tax blunders that affect many estate plans. These seemed spot on and worth elaborating on. As part of your annual estate and financial planning checkup (you are getting annual reviews, aren’t you?) discuss with your planning team these three issues to see if they affect you and if they do what you might do to address them.

Not fixing FLPs

Family Limited Partnerships (“FLPs”) and Limited Liability Companies (“LLCs”) were often formed to hold family investment or business assets for one of or more of the following reasons. One reason: Valuation discounts for estate and gift tax purposes. For example, if an FLP owned $5 million of assets a 20% interest may not be valued at $1 million but rather at something less, perhaps $700,000 due to the holder of a mere 20% interest not having the ability to control distributions, liquidation, etc. Such a non-controlling interest might not be readily saleable. Those discounts leveraged estate and gift planning. Another common purpose for FLPs and LLCs was to exert control. Mom could set up an FLP to hold family investments and even if she gave away most of the interests, she might still be able to control the entity. This could have enabled her to control investments, distributions and more. Finally, FLPs and LLCs were often created to provide asset protection. If a claimant sued a family member who owned an interest in the entity, and especially a non-controlling interest, the claimant might be hampered in realizing value on that claim. In many instances all the claimant could receive would be what is called a charging order protection, meaning the claimant could receive only whatever distributions the holder was to have received on that interest. That can be a rather significant disincentive to a claimant.

So, what are some of the issues with FLPs and LLCs? Too often folks neglect proper maintenance and formalities. If the appropriate requirements are not adhered to, all of the intended benefits from the FLP or LLC could be jeopardized. If personal assets are commingled with entity assets, e.g. bank funds, courts, and the IRS may both disregard the entity negating tax and asset protection benefits. If legal formalities of having a signed and current governing instrument (partnership agreement for an FLP or operating agreement for an LLC), proper legal transfer of assets to the entity (e.g. a deed for real estate), and so on are ignored, the entity may also be disregarded. So, you have to have the documentation and operation of such entities reviewed regularly and fix any issued identified.

There is another major issue for many FLPs and LLCs. Some of these entities were created to provide planning discounts when the estate tax exemption was perhaps a mere $1 million, not in 2019 when it’s $11.4 million per person. Thus, many of the FLPs and LLCs were created to avoid a gift or estate tax that is not relevant under current law. Worse, when the owner dies those discounts that were once sought after becoming a tax detriment in that they reduce the value to which the assets can be increased (stepped-up) on death. Some FLPs and LLCs might, if valuation discounts were the only benefit, be best dissolved to negate the discounts that have now become detrimental. While that might sound seductive, it may be the wrong answer. If the Democrats take over in 2020 and enact transfer tax changes similar to those proposed by Senator Bernie Sanders, it might have been better to leave the entities in place (and perhaps even better still to do more planning with those entities now like more gifts to reduce potential future estate taxes).

The reason for the valuation discounts is the onerous restrictions contained in the governing documents for the FLP and LLC. But, apart from taxes, these restrictions themselves might raise issues. The next generation may not be happy if they are locked into the restrictions. They may not get along and may not want to be bound to each other. It’s one thing to have a family consisting of parents and children in an entity but will the next generation want to have those ties? Often not.

The moral of the story is that every estate plan that includes an FLP or LLC should meet with its adviser team and examine whether the initial reasons for creating the entity remain, and if not, what should be done to address it. If one or several benefits remain from the entity, what steps can be taken to enhance the likelihood of achieving those goals? In many cases, revising the legal documents for the entity, correcting what is almost inevitable oversights in operations of the entity, and more will prove advisable.

Not Swapping Out

Many irrevocable trusts include swap powers. Irrevocable trusts have traditionally been defined as trusts that cannot be changed, although the evaluation in trust law has created many exceptions to the old notion of no changes. Irrevocable trusts are often used to remove assets from your estate to save estate taxes, and/or for asset protection, and other reasons. Many of the irrevocable trusts formed for many years have been structured for income tax purposes to be characterized as “grantor” trusts. This means that the income of the trust is reported on the income tax return of the person who created the trust (called the “grantor” or “settlor”). So, the settlor, not the trust, pays income taxes. That can be a good thing to reduce the settlor’s estate. Although, for some, it can be too much of a good thing and feelings about it change, with the settlor tiring of the costs. While there are many ways to achieve grantor trust status, a common one has been to give the settlor the power to swap or substitute personal assets for trust assets of equivalent value.

Example: Jane created a grantor trust in 2012 that included a swap power. She transferred $2 million to the trust in 2012 out of fear that the estate tax exemption might have dropped in 2013 to $1 million (it did not). Jane is in her late 80s. The $2 million of securities has appreciated to $6 million. If Jane dies the $6 million is outside her estate. That might be beneficial. But the income tax basis of the stocks in the trust is quite low. If they remain in the trust there will be no change in the income tax basis on Jane’s death. However, if Jane were to swap or substitute in cash (which she might borrow if she does not have it) into the trust in exchange for the securities, those securities would then be included in her estate. On Jane’s death, the income tax basis of the securities will be adjusted to their fair market value on her date of death. That may well result in a large increase or step-up in the income tax basis of those stocks, thereby eliminating capital gains costs.

What’s the big issue with swap powers? Who is watching them? Too often no one is paying attention to these powers. If ignored, the income tax consequences could be very costly. If you have irrevocable trusts both you and the trustee should be aware of the swap powers they might contain. You should review the appreciation of trust assets at least annually, and perhaps more often if your health is questionable or your age advanced, or after large movements in asset values. You should plan ahead of time to arrange lines of credit to fund a swap. In some instances, it may be advisable for you to have your attorney prepare the legal documents necessary for a swap in advance so if health issues warrant the swap can be exercised quickly. If your trust has significant marketable securities, your investment adviser should monitor the appreciation. If you are going to exercise a swap power your estate planning attorney should be involved to assure that the swap is handled in conformity with the rules contained in the trust document (no they are not all identical). Your CPA must be informed of all of this so it can be reported properly not only on tax returns but also on any balance sheets prepared for you or the trust.

No Selection of Trust Situs

Trust situs is the state where your trust is based. This will often mean that the trust is administered and the state law that governs the trust. The simple and obvious answer for trust situs and the one most often used, is that a trust is created in whatever state you reside in. But simple is not always best. Does your home state provide a good environment for your trust? That environment will include state law that is supportive of the goals you have for the trust. What about state income taxation? If your home state has a harsh income tax system, perhaps you could defer that tax or even avoid it, if your trust were based (has situs) in a better state that has more favorable tax laws?

Effectively you can “rent” a better trust jurisdiction to avoid state income taxes. If the true cost after factoring in compound interest and the cost to rent the jurisdiction (e.g. legal fees to set up a trust in that jurisdiction, trustee fees to an institution to create the connection or nexus to that jurisdiction, etc.) is favorable, it may be worth doing. The selection of situs is often not adequately discussed for creditor rights purposes. Some states simply have laws that are more protective of trust assets than other states.

What can you do? When planning any new trust, discuss with your estate planning attorney the pros and cons of which state to use for the trust. For existing trusts, meet with your planning team and discuss the possible change in situs for the trust. That might be feasible under the trust agreement, and if not, it might be possible to decant (merge) the existing trust into a new trust that will be based in a better jurisdiction.

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