Time to Review Your Estate Planning: Take Advantage of New Opportunities and Avoid Pitfalls
In December, 2010, Congress passed and President Obama signed into law new tax legislation which drastically changed the Federal Estate Tax. Now that the Estate Tax has returned in full force, taxpayers can once again focus on estate planning as the exemption for both gift and estate tax increased to $5 million ($10 million for a married couple) and the rate decreased to 35 percent. Even in a depressed market, real estate assets should be considered a vehicle for exceptional benefits.
Real estate by its nature is not an extremely liquid asset and can create problems for the estate of real estate rich, but cash poor, decedents. Many taxpayers, on the advice of their lawyers and accountants, have structured their real estate holdings through a family owned limited partnership or limited liability company (FLP). This structure was generally put into place to reduce the value of the assets for estate tax purposes through the use of valuation discounts for lack of marketability and for lack of control. In a series of recent court cases, the IRS has successfully attacked the claimed valuation discounts. Accordingly, it is vital that anyone holding interests in property (real or otherwise) through FLPs review and potentially revise their organizational documents to defend against this IRS attack.
The value of any asset, such as an interest in a FLP holding real estate owned by a decedent at the time of their death, is included in the decedent's estate for estate tax purposes. The value of an asset is defined by the IRS as the amount a willing buyer would pay a willing seller with both being knowledgeable of the relevant facts and circumstances and neither being under a compunction to buy or sell. This value can be greatly impacted by the form of the ownership of the asset. Assets owned directly would be valued at the full fair market value of the asset, whereas the value of assets held through an entity may be subject to discounts for lack of marketability and for lack of control. These discounts can often exceed 50 percent of the fair market value of the underlying property. The magnitude of the relevant discounts used to determine the fair market value depends on a variety of factors, including earnings and distribution history, the existence of a readily available market for the interests, the respective rights under the agreements and state law for the minority owner to demand distributions or expectations regarding sales of the underlying assets or dissolution of the entity. A significant factor in determining the discounts used to value interests in entities is whether the interest has voting rights or is nonvoting. Nonvoting minority interests that have little or no control rights under state law are valued at substantial discounts.
Many FLPs were formed to specifically take advantage of these discounts and created nonvoting limited interests as part of their structure to maximize the available discounts for gift and estate tax purposes. In a recent trend in the courts, the IRS has been able to use the control features retained by the founders of these types of entities to assert the full value of the underlying property as includable in their estates. In these cases the decedent had retained the sole voting authority over the entity that held the property. This triggered a provision in the estate tax law which deals with the inclusion of property in the estate where the decedent has retained the right to control the beneficial enjoyment of property, including voting control of stock in closely held corporations.
In light of these recent cases, anyone who holds real estate through a closely held family entity must review the organizational documents to ensure that voting rights have not been retained by the senior generation, and that the agreements comply with the latest line of case law. When establishing family owned entities to hold interests in property, the agreements should be crafted to avoid these new pitfalls. This may be easier said than done. Very often, the founding member of the family real estate business is more concerned with the retention of control than with a potential estate tax. There are other means to effectively provide the founder with the control they need to run the business without running afoul of the estate tax rules. For example, the founder can establish trusts for family members with a "friendly" trustee to hold interests for other members of the family. These trusts may provide the additional protection of providing the family members with asset protection features, insulating the assets from attack by creditors and spouses (in case of divorce).
This article first appeared in the June 2011 “Money Sense” section of Mercer Business. Reprinted with permission.