AN interesting article in Newsweek entitled, "Darling, It'll All Be Yours—Soon," got me thinking. The article explains how "the inheritance boom is quietly reshaping how we think about death." How true.
When I began my professional practice (as a CPA and lawyer back in the '50s), a millionaire was hard to find. Today, millionaires are bountiful. And when it comes to estate planning, they try to find a professional who can lower their estate tax liability before the proverbial bus hits them. The Newsweek article, like so many other articles, explores the problem, but it offers no solutions.
Let's set the scene for how you (whether you are the parents or the kids) can, in fact, solve the problem. Let's start with the elders, mom and dad, who have the wealth.
Fact No. 1: You ain't dead yet. Typical estate plans (separate will and trusts for him and her) don't speak until you are dead: too late to beat the tax collector. The solutions lie in lifetime planning. A lifetime plan keeps you in control of your wealth for as long as you live, yet transfers it—including your business—to your kids (and grandkids) while you're alive.
Fact No. 2: Years of experience has taught us that wealth is always passed on to the younger generations of the family. And then the younger generations step into mom and dad's shoes and increase the family wealth. This gives the second generation an even bigger estate tax problem than mom and dad had.
Here's how we solve this do-not-enrich-the-irs problem: Logic tells you that the children, particularly the business children, are likely to become wealthy. Usually, these children accumulate more wealth than mom and dad, to be repeated again when the family wealth goes to the grandchildren two generations later. Because of this generation-to-generation wealth transfer pattern, we view each generation of the family separately in terms of their special needs and objectives. Yet, the plan is not just for mom and dad, it is a comprehensive plan for the entire family. Following is an overview of how it's done.
First generation. Install a lifetime plan that removes wealth from your taxable estate during your lifetime. Use strategies like: 1) a qualified personal residence trust for your home; 2) a grantor retained annuity trust for your business; 3) a subtrust for your profit-sharing plan, rollover IRA and similar plans; 4) a family limited partnership for your other assets; and 5) an irrevocable life insurance trust for insurance, probably second-to-die.
All these strategies—and there are others—begin their work now, while you are alive and in control.
Of course, we'll dovetail your will and trust (death documents) with your lifetime plan. But when done right, your death documents just clean up what's left. The first part of the family plan and your wealth transfer were completed tax free, while you and your spouse were alive.
Your kids— second generation. After completing the plan for mom and dad, it is easy to project what the financial future of the kids might look like. So, as soon as we finish the plan for the fIRSt generation, we start a plan for each of the kids, based on their individual assets and objectives.
The process is the same as for mom and dad, but flexibility (this generation usually is still in the process of trying to accumulate wealth, rather than trying to get rid of it for estate-tax purposes) is always a key objective of the second generation.
Your grandchildren—third generation. The plans for this generation are closely tied to the plans of the two older generations. Probably the most important point to keep in mind is that because of the young ages in this generation, getting the children into a tax-free environment as soon as possible is a wealth-building must.
These plans center on short-term and long-term tax advantaged strategies that fulfill lifetime needs: education, buying a house, starting a business and (if they don't go into the family business) building a retirement fund.
A valuation victory A simple question: How much would you pay for a property worth $10,000 if you must spend $3,000 (for repairs, commissions or special taxes) before collection of your $10,000? Certainly not more than $7,000, less if you wanted to make a profit.
Yet, over the years the IRS and the courts just didn't understand the basic economics in the real world. Now they do. Here's the story:
Let's set up a scenario that is repeated every time owners want to sell their businesses. If you are a potential buyer, generally you are willing to pay more for the individual assets owned by the corporation than the corporation's stock. You do this for two reasons: to obtain a higher tax basis for the low-basis assets owned by the corporation and to avoid hidden liabilities. But now look at the seller's side of the coin: After the acquired company sells its assets, it will owe corporate income tax on any gain.
On the other hand, if the shareholders sell their stock, they will pay less tax. But the low-tax basis of the assets stays with the corporation. Sorry, when the buyer (really your acquired corporation) sells these assets, the corporation will be socked with the tax on the gain.
Despite this reality, up until now the IRS and the courts have never allowed a reduction in the value of corporate stock for potential taxes due on a future asset sale or corporate liquidation. Sound the victory bell: Two recent cases allow such a discount for the fIRSt time.
Case No. 1. Estate of Artemus Davis, (110 TC 530-1998). Davis, one of the founders of the Winn-Dixie grocery chain created a holding company to own some of his publicly traded Winn-Dixie shares. Davis gave about a 26% interest in the holding company to each of his two sons. At the time of the gift, the holding company owned $70 million of Winn-Dixie stock and $10 million of other assets.
Davis claimed three discounts on his gift tax returns to report the transfers: 1) lack of marketability; 2) minority interest; and 3) for the corporate taxes due if the Winn-Dixie stock were to be sold. The total of these discounts reduced the value of the gifted stock by more than 60% when compared to the real value of the holding company's assets.
The IRS rejected the valuation and assessed additional gift taxes of $5.2 million. Davis fought the IRS and when he died, his estate continued to fight. Bless the Tax Court for holding that a discount for taxes must be allowed. The court saw no way the holding company could avoid the taxes and allowed discounts totaling 50% of the value of the assets.
Post this article on the wall. When you want to transfer your business for tax purposes, reread it. Hey, that's about $500,000 off of every $1 million your business is worth.
Case No. 2. Irene Eisenberg (155 F3d 50-1998). In this case, the corporation owned real estate that it rented to third parties. The Second Circuit concluded that a similar discount for taxes was appropriate in valuing stock in a holding company.
And here's one more reason to keep this article handy. We often use a family limited partnership to beat up the IRS legally. A flip usually owns real estate and marketable securities just like the two cases discussed above. These two victories give us big-gun ammunition should the IRS get any low-discount ideas.
Irving Blackman is a partner in Blackman Kallick Bartelstein, 300 S. Riverside Plaza, Chicago, Ill. 60606; tel. 312/207-1040.