WealthDirector

WealthDirector

Private Wealth Developments and Observations

Tax Court Rules Corporate Merger of Family-Owned Businesses Results in Substantial Taxable Gift

Posted in Tax

In September, the Tax Court issued its opinion in Cavallaro v. Commissioner, T.C. Memo 2014-189, holding that a merger of two family-owned businesses resulted in a $29.6 million gift from Mr. and Mrs. Cavallaro to their three sons.

Background

Mr. Cavallaro started a tool manufacturing company called Knight Tool Co. (“Knight”). Knight was co-owned by Mr. and Mrs. Cavallaro. As his sons became adults, all three were  involved in the business. In the 1980s, Knight developed what turned out to be a valuable technology for applying liquids during the manufacturing process. In the late 1980s, the sons formed Camelot Systems, Inc. (“Camelot”), which would exclusively sell Knight’s products. The Cavallaro sons each owned one-third of Camelot.

In the mid-90s, due to the rise in value of the technology, Mr. and Mrs. Cavallaro sought estate planning advice. The Cavallaros sought advice from their CPA and an estate planning attorney. Both advisors separately recommended merging Knight and Camelot. After the merger, the Cavallaros would own the surviving company, with each shareholder’s ownership proportionate to his or her relative ownership and the value of the shares owned in Knight and Camelot, respectively.

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IRS Attempts to Simplify the Application Process for Certain 501(c)(3) Organizations, but is “EZ” Better?

Posted in Tax

On July 1, 2014, the Internal Revenue Service (“IRS”) released Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code (“Code”).

Form 1023-EZ is an abbreviated version of the twelve page Form 1023 (which can be supplemented by as many as seven schedules) and is intended to streamline the application for recognition of exemption under Code §501(c)(3) for certain organizations.  Such organizations are those with gross receipts of $50,000 or less and assets of $250,000 or less and are otherwise eligible to file the Form by being a public charity described in Code §§170(b)(1)(A)(vi) or 509(a)(2), a private foundation, or an organization seeking reinstatement of exempt status pursuant to section 4 or 7 of Revenue Procedure 2014-11 following automatic revocation of such status for failure to file required annual returns or notices for three consecutive years. Continue Reading

Keep Your Collection Away from the Collectors: Tax Planning for Fine Art

Posted in Estate Tax, Tax

Artwork Tax PlanningAppreciation of fine art can create challenging tax issues, but with proper planning collectors can minimize the estate, gift, and income tax consequences of their collections.

For taxpayers hoping to keep their works in the family, a recent 5th Circuit Court of Appeals ruling provides some promising precedent for valuation issues. In Estate of Elkins v. C.I.R. [1], a deceased taxpayer had gathered an impressive collection of fine art with a fair market value (“FMV”) of roughly $35 million. Mr. Elkins and his wife, partially motivated by concerns about future estate tax liability, distributed fractional ownership shares in two groups of paintings to their three children. At the time of his death, Mr. Elkins retained a 50% interest in three works of art with a cumulative FMV of approximately $10.5 million and a 73% interest in a group of 61 pieces of artwork with a cumulative FMV of about $24.5 million. This division of ownership is a common tactic for passing assets to family members. The benefit lies in valuations for estate tax purposes, which may include large discounts from FMV to reflect the unenviable position of an unrelated prospective buyer owning a partial stake in a family asset with limited marketability. However, the IRS has seldom applied such discounts to partial ownership interests in pieces of fine art. In Elkins, the Commissioner argued that no discount at all could be permitted while the estate had calculated a discount of 44.75% for the entire collection. The Tax Court found neither argument appealing and instead applied a 10% discount across the board. The Elkins estate appealed the ruling and the 5th Circuit granted the estate a $14 million refund plus interest while applying discounts ranging from 50%-80% to the different ownership shares. The ruling provides some support for wealthy families considering fractional interests for their art collections. But complying with the letter of the law, which requires possession by each owner commensurate with their percentage interest, remains a challenge. In addition to discounted valuations, taxpayers with valuable collections can mitigate estate and gift tax consequences by removing value from their estate within the limits of annual and lifetime gift tax exclusions or by making gifts to an irrevocable trust with Crummey [2]withdrawal powers for the benefit of each of their children and grandchildren. Continue Reading

Colorado Court Leaves Valuation Question Unanswered When Valuing GRAT Appreciation

Posted in Colorado, Estate Planning, GRAT, Uncategorized

On March 20, 2014, the Colorado Court of Appeals, in Malias v. Malias, upheld the trial court’s determination that grantor retained annuity trust (GRAT) remainder interests were “property interests” for property division purposes,  and the corresponding valuation of the GRAT interests for those purposes.  Although the case has not yet been selected for publication, it provides interesting insights for both estate planners and family law practitioners.

In Colorado, determining the disposition of trust property between divorcing parties is a two-step process.  A court must first determine if an interest in trust constitutes a “property interest,” and if so, must then decide whether it is “separate” property or “marital” property.  Colorado statutes provide a rebuttable presumption that all property acquired after the marriage is marital property, except for gifts, inheritance, property acquired in exchange for separate property, and property excluded by agreement between the parties.  Marital property also includes appreciation of, and income earned from, a spouse’s separate property, including gifted property.

Husband and Wife were married in 1999.  In 2003, Husband’s parents created GRATs for the benefit of Husband and his brothers. The GRATs had four year terms and were funded with stock in Husband’s family’s business.  The value reported for gift tax purposes of the GRAT established for the Husband was $2,341.  At the GRAT’s termination, the value distributed to Husband exceeded $7 million. Issues reviewed on appeal, among others, were whether the trial court erred in determining that the GRAT remainder interests were property interests for property division purposes and whether its valuation of those interests was reasonable.

The appellate Court first upheld the trial court’s finding that Husband’s GRAT remainder interests were property interests.  The Court based its decision on the facts that the GRATs were irrevocable and Husband’s remainder interest was subject only to his surviving the GRAT’s four year terms.  Citing Colorado case law, the Court stated that Husband’s remainder interest was a “‘certain, fixed interest’ sufficient to constitute property for purposes of Colorado law.” As a property interest, the GRAT’s appreciation from the initial creation of the GRAT constituted marital property.

The Court next addressed the trial court’s valuation of the property interest for purposes of determining appreciation.  Each party’s expert testified that the purpose of GRAT planning is to remove any appreciation realized during the term of the GRAT from the grantor’s estate.  Wife’s expert testified that the value reported on Husband’s parents’ 2003 gift tax returns reflected the appropriate value of the GRAT remainder interests gifted to Husband because that value accounted for the uncertainty of any future appreciation. Husband’s expert explained that aggressive planners seek to “zero” out remainder interest values and, therefore, the gift tax values were artificially low compared to the contributed property’s actual value.  But, the Court noted that Husband’s testimony revealed that he disagreed with the gift value only because he did not consider Husband’s remainder interest to be property until the GRAT terminated and Husband received the distribution.  Husband’s expert did not challenge the accuracy of the gift tax values nor did he offer any alternative valuation or valuation methodology.

The Court affirmed the trial court’s decision to value the property interests by utilizing the value reported for gift tax purposes as of the date of the gift.  Specifically stating that the gift tax returns were the only evidence of value available, the Court held that the record supported the trial court’s decision to adopt the values reported for gift tax purposes.  And as a result, almost the entire value distributed to Husband at the GRAT’s termination was appreciation constituting marital property subject to division.

If the Court had been provided with alternatives for valuing the assets on the date of their contribution to the GRATs, would the Court have made the same value determination?

Income Tax Reporting for Decanting

Posted in Estate Planning, Income Tax, Tax, Trust Administration

Decanting refers to the distribution of trust property of one trust (the “first trust”) to another trust (the “second trust”).  Over the past several years, the number of states specifically authorizing decanting by statute has grown rapidly.  As of March 2014, at least twenty-two states have passed or proposed a state decanting statute.

Notwithstanding this proliferation of decanting statutes at the state level, the Internal Revenue Service (the “IRS”) has not provided authoritative guidance regarding the proper tax treatment of decanted trusts.  In Notice 2011-101, the IRS invited comments from the public regarding the income, gift, estate and generation-skipping transfer tax issues arising from decanting.  In response, the IRS received comments from many well-respected national groups but still has not issued guidance.  In fact, to the contrary, the IRS continues to list certain decanting transactions on its “no ruling list” pursuant to Rev. Proc. 2014-3, and has not added decanting to its Priority Guidance Plan, all of which suggests that guidance will not be forthcoming in the near future.  Meanwhile, trustees decanting trusts today must determine with their legal and other tax advisors how to report the distribution of trust assets from the first trust to the second trust without such guidance.

With respect to income tax reporting, one issue all trustees decanting a trust will face is whether the second trust should be treated as a new trust or a continuation of the first trust for income tax purposes. Continue Reading

SEC “Common Trust Fund” Exception Narrowly Construed for Private Trust Companies

Posted in Estate Planning, Trust Administration

Recent years have seen a dramatic increase in the number of Private Trust Companies (“PTCs”) established by wealthy families.  PTCs are used to consolidate the trustee function of multiple trusts within a family, and because these trusts are often invested in family-controlled investment vehicles they implicate various federal securities laws.  For instance, the Investment Company Act of 1940, which regulates mutual funds and other pooled investment vehicles (the “1940 Act”) may require significant review and planning for large families considering considering use of a PTC.  Compliance with 1940 Act registration and ongoing regulatory requirements can be extremely burdensome, and therefore we, as advisers, are often faced with the challenge of navigating the maze of exceptions available under the 1940 Act.

As a general rule, there is an exception to the registration and other requirements of the 1940 Act for investment vehicles (such as partnerships or limited liability companies) which have fewer than 100 investors, or whose owners are all “qualified purchasers” (generally a person with over $5 million of investments).  While the 100 investor limit would seem generous in a family context, it is not out of the question that a multi-generational family could have in excess of 100 investment accounts after counting all trusts and individual family members having separate accounts, and therefore fail to qualify for this exception.  Likewise, it is not often the case that all investors are qualified purchasers.  In these situations, a family must seek another exception from the 1940 Act. Continue Reading

IRS Issues Warnings about Email and Telephone Tax Scams

Posted in Income Tax, Tax

As the 2014 tax filing season progresses the Internal Revenue Service has issued warnings to taxpayers about convincing fraudulent email messages and telephone calls seeking payments or personal information that will enable the scammer to directly or indirectly steal from the victim.  All taxpayers should keep in mind that the Internal Revenue Service never initiates contact with taxpayers by email, text or social media, and never asks for credit card, debit card or prepaid card information over the telephone.  A taxpayer who is contacted by telephone by a person claiming to be an IRS representative should not divulge any personal information, should request a written follow-up communication and should confirm the validity of any such communication by contacting the IRS directly at 1-800-829-1040.  The links above provide instructions for reporting suspected fraudulent activity.

The Waiting Game: What to Do (and Not Do) While an Exemption Application is Pending

Posted in Estate Planning, Tax, Uncategorized

So, you have thoughtfully and thoroughly prepared the Form 1023 Application for Recognition of Exemption Under Section 501(c)(3) (“Form 1023” or “application”) on behalf of a charity, and filed it with the IRS along with a completed checklist and the correct user fee.  The charity is now anxious to fundraise and accept donations, commence its charitable programs, or start making grants. Now what?

Once upon a time you could reasonably approximate the processing time for a Form 1023, based on various facts and characteristics.  A non-operating private foundation that only makes grants to domestic public charities?  One could anticipate receiving a favorable determination letter in three to six months.  A public charity with highly compensated employees, joint venture activity, affiliated entities, and/or and foreign activities?  One could similarly predict a longer processing time and greater likelihood that the IRS would respond with questions and a request for further information, regardless of how carefully the Form 1023 was prepared. Continue Reading

U.S.TAX COURT DECISION MAY ALLEVIATE THE 3.8% NET INVESTMENT INCOME TAX BURDEN FOR MANY TRUSTS

Posted in Estate Planning, Income Tax, Tax, Trust Administration

Because trusts are subject to the 3.8% Net Investment Income Tax at a very low income level, $12,150 for 2014, trustees of trusts owning interests in operating entities have been considering ways to meet the material participation requirements to avoid this tax.  As discussed in a prior post, differing points of view have arisen regarding determining whether trusts can actively participate in entities in which they own interests.  The conflicting positions of the Internal Revenue Service (Technical Advice Memorandum 201317010) and case law (Mattie K. Carter Trust v. U.S.) have caused uncertainty as to whether active participation can be satisfied by the trustee, the officers, employees, agents or beneficiaries of a trust.  This week’s long awaited United States Tax Court decision in Frank Aragona Trust et al. v. Commissioner; 142 T.C. No. 9 was a big win for many trusts.

In the Frank Aragona Trust case, the Tax Court disagreed with the Service’s arguments that a trust was incapable of providing “personal services” to meet the material participation test under IRC § 469 (c)(7).  The Service argued that “personal services” are defined to mean “any work performed by an individual in connection with a trade or business” and, because the trust was not an individual, it could not perform those personal services.  The Tax Court held that services performed by individual trustees on behalf of the trust may be considered personal services performed by the trust.  The Tax Court then further disagreed with the Service’s attempt to exclude from actions counting toward material participation the actions of the trustees who were also employees.  Noting that the trust had no business activities other than real estate and that a majority of the trustees participated in these activities, the Tax Court concluded that the activities of the employee-trustees should be considered in determining whether the trust materially participated in its real estate operations.

This decision only covers situations in which the trustee is materially participating in the trust activity.  Although the Tax Court did not go as far as the Mattie K. Carter Trust case in which the Texas U.S. District Court solely relied upon participation of trust employees in determining whether the trust materially participated in an activity, it did open the door to participation closed by TAM 201317010.  This decision provides clarity for practitioners and is a big win for many trust clients.

Will Camp Tax Plan Impact Charitable Giving and Tax-exempt Organizations?

Posted in Estate Planning, Income Tax, Tax

Capitol hillIn late February 2014, House Ways and Means Committee Chairman Dave Camp (R-MI) released a nearly 1,000 page discussion draft addressing tax reform.  Chairman Camp’s proposal includes changes to numerous sections of the Internal Revenue Code, including changes with respect to the taxation of individuals, capital gains and businesses.  The discussion draft also includes changes relating to charitable giving and tax-exempt organizations.

The current sense of most political prognosticators is the Camp proposal has little chance of being enacted into law in the near term.  Notwithstanding that the proposal is likely a “dead letter” in its current form, it is significant because it may well provide a framework for future tax legislation, including provisions impacting charitable contributions and tax-exempt organizations.

Charitable Giving.  Chairman Camp’s proposal includes several potential changes to the rules applicable to charitable giving, including:  Continue Reading