Large Estate Gifting & Bequests to Multiple Generationsby Frank Heinisch, Christin Lovegrove on 05/25/15
Large Estate Gifting and Bequests to Multiple Generations
By: Frank C. Heinisch
Quackmore and Hortense Duck have one son, Donald Duck (who is married for the purposes of this article). Donald and his wife have three children: Huey (who is married and has no children of his own), Dewey (who is married and has three children of his own), and Louie (who is divorced and has two children of his own).
Quackmore and Hortense Duck have an estate valued at about $14.5mm, mostly comprised of separate pieces of farm ground. The exempt level is $5.430mm times 2 or $10.860mm with a federal estate tax rate of 40% that would result in a federal estate tax of $1.456mm on $3.64mm if nothing is done.
First level: place the farm land in an entity such as an LLC and claim a discount for minority interest and lack of marketability of 25%. Without an appraisal, a discount of 20% to 35% is generally permitted depending on circumstances. The higher the discount the greater the risk of an audit and the necessity of proving the discount by expert appraisals.
The real estate value at $9k per acre is $13.250mm. A 25% discount is $3.312mm and a 30% discount is $3.975mm. A 30% discount would eliminate the federal estate tax if the values were accepted.
Second level: make annual gifts of the LLC units of $14,000 per year per donor per donee (the gift tax exemption for reporting purposes). Quackmore and Hortense can give a total of $28,000 per year per person. A gift to Donald, his wife and 3 children, a total of $140,000 (5 x $28k) per year reduction in the estate value. The gifted LLC units would be valued with the discount for minority interest and lack of marketability. $200k of land x 30% discount is $140k that can be removed from Quackmore and Hortense’s estate each year.
I suggest gifting to the 5 great grandchildren. Another 5 gifts would reduce the estate by another $200,000 x 30% discount = $140,000 (5 x 2 x $14k).
Hortense wants to keep the gifts equal between the grandchildren. That being the case, there should be 9 gifts for great grandchildren: 3 for Huey with no children, 3 for Dewey’s 3 children and 3 to be divided between Louie’s 2 children.
Gifts to grandchildren and great grandchildren are generation skip transfers, subject to generation skipping transfer taxes 40% and, in addition, to federal estate tax of 40%. The tax computation is complex, but could exceed the amount of the gift with the generation transfer tax computed on the amount of estate tax paid. The allocation of generation skipping transfer tax exemption is more complex than the tax computation, especially with the interplay between gift taxes and estate taxes and generation skipping transfer taxes.
The bottom line is that generation skip gifts and bequests are great as long as you stay under the Generation Skipping Transfer Tax [GSTT] exemption, $5,430,000 (same amount as the estate tax exemption [unified credit]). The annual $14,000 gifts are also exempt from Generation Skipping Transfer Taxes. The idea is that IRS wants to tax each generation and if generation is skipped there is a double tax, if not more, unless the transfers are less than the exemptions.
Thus, $14,000 annual gifts are great and do not use up the Estate Tax exemption or the Generation Skipping Transfer Tax exemption. Note that the $14,000 includes all gifts in the year, e.g., birthday, Christmas and the annual gift. If all the gifts to a single donee exceed the $14,000, a gift tax return is required and the life time estate tax exclusion is decreased. The $14,000 (current as of 2015) is indexed to change with inflation.
The problem is that the annual gift must be a present interest gift, that is: the donee has immediate access to the gift. A gift to a grandchild or great grandchild of LLC units worth less than $14,000 in 2015 is a home run--free of taxes.
But a gift to a trust is not a present interest gift since there are strings attached per the terms of the trust. The Crummey Family won the case where a gift made to a trust is a present interest gift if the donee has a right to withdraw the gift after notice and a reasonable time limit (90 days). If the power to withdraw is not exercised, it lapses which normally is a gift from the donee. (In other words, the donee had the right to take the LLC units and failed to take the LLC units which is a gift back from him to the trust.)
The lapse of a $5,000 (or 5%) less current power to withdraw from the trust is de minimis and not considered a gift. Thus, gifts of $5,000 (or 5%) or less to a trust with a Crummey power to withdraw the gift after notice within a reasonable time is a present interest gift free of federal estate tax and free of Generation Skipping Transfer Tax.
The $5,000 de minimis rule alterative limitation is the greater of $5,000 or 5% of the value of the trust. If the trust value is $280,000 then the $5,000 is increased to $14,000 (5% of $280.000).
A hanging Crummey Trust power of withdrawal can be added to the trust that provides that if the power to withdraw is greater than the de minimis rule, then the right to withdraw is continued until there is trust value for the 5% limitation to fulfill the de minimis rule.
Remember gifts to grandchildren and great grandchildren are generation skipping events.
Thus if the value of the donor’s share of the trust is in excess of $280,000 the 5% rule will meet the annual exclusion. When there are multiple donees, computations will have to made to be sure the donor has adequate value in the trust to fund all the potential 5% withdrawals. Still the $280,000 minimum value should be adequate. Payment of the withdrawals may be in kind, that is: units of the LLC, not in cash.
We provide that those qualified to withdraw may be removed with regard to any future gifts, leaving leverage that generally persuades the person with the power to withdraw to be hesitant in the exercise their power to withdraw (because it may preclude future gifts to him or her).
In transferring assets upon death the rules of annual exclusion and present interest gifts do not apply. Upon death, units of an LLC may be transferred by Will or by Trust. The Will may create a Trust within the Will or transfer to a Trust then in existence.
The transfer of LLC units may be made directly to a beneficiary or held by a Trustee for the benefit of a specific beneficiary for a term (an age, or it could be for life). If the beneficiary is a class and the trustee has discretion in determining distribution, the beneficiary or creditors of a beneficiary have no identifiable right to trust assets. This is helpful if a great grandchild is applying for college assistance and, thus, would not need to disclose assets held in trust for them. Also a trust created by a third party with discretionary distributions is not a disqualifying resource for Medicaid. Only the amount distributed is considered a disqualifying resource.
The Federal Estate Tax exemption of $5.430mm per person can be shared between husband and wife. If all is not used by the first to die, the unused portion is available upon the death of the survivor as long as they have not remarried. This is called portability. Generation Skipping Transfer Tax exemption of $5.430mm has no portability. If the GSTT exemption is not used on the first death, it is lost. If, upon death, substantial value is to be transferred to the grandchildren or great grandchildren, provision should be made for each estate of Quackmore and Hortense to have in their name sufficient assets to give by will either directly or by trust to skip generations.
Remember that an LLC is normally taxed as a partnership, with each member having taxable income corresponding to their ratio of the LLC. Customarily, the LLC distributes funds to help the member pay the income taxes on their share of the LLC income. Such distributions are not mandatory. Distributions should be made in proportion to numbers of units owned and different members have different tax rates; thus some will have more than taxes reimbursed to make the distributions equal.
I suggested two LLCs: one for gifting and one to shelter the rest of the land to gain death tax valuation discounts. Gifted LLC units have no step up in basis upon death, therefore the land gifted to Mallard LLC should have a high basis. The income earned by the gifting LLC may be easier to control with transfers to Mallard LLC of one or two quarters. The rest of the land can be owned by Drake LLC. Some time in the future the two LLC could be merged, but keeping the gifting LLC smaller will have benefits of keeping the rest of the farm land, Drake LLC, segregated.
Gifts of the Drake LLC could be made outright to Donald and his wife each year. Everyone else would receive Mallard LLC gifts. The Mallard LLC gifts can be in trust or outright generation skipping gifts.
Ultimately, how long the trusts should last is a hard question? After Quackmore and Hortense pass, should the trust continue for Donald’s life then Huey ’s life or should Huey have the authority to extend the term of the trust? Upon termination of the trust the LLC units are distributed and the members decide to continue or sell the farms by a majority vote or will a super majority vote be required? With the LLC, a partition sale of the farm land cannot be forced. Generally, control of the LLC is by a majority of members although members may have non-voting units.
The trusts and LLCs can have whatever rules Quackmore and Hortense establish.
Consider Donald as trustee and if he fails or declines to serve as trustee then Huey; and if he fails or declines to serve as trustee a committee of your grandchildren decide the successor trustee.
The law is unsettled on whether the LLC earnings are subject to the 15.3% self-employment tax to all members. The argument against self-employment tax is that members that are not active in the LLC business are receiving a return on their capital, not earned income. S Corporation status recognizes earned income subject to self-employment tax and passive income from return on capital. This is not established for LLCs. As the income distribution increases for inactive members, it may be appropriate for an S Corporation election to escape self-employment tax. An excellent discussion of this issue was in Forbes, September 10, 2012, and is available on the internet: http://onforb.es/1BsmVFX.
This issue of all earnings being treated as self-employment income to all members from an LLC may increase the self-employment tax for Quackmore and Hortense where we now treat rental income as not subject to self-employment tax. An option is to have Drake as a S Corporation and Mallard as an LLC. An interesting twist is to have trust ownership of LLC membership units which will further confuse the earned income, self-employment tax approach. If the LLC pays a management fee (to Donald or Huey) that may further differentiate between active earned income and return on capital income for the LLC.
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