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Oxford Financial Group, LTD


Oxford Financial Group, LTD


Expert Perspective

News, research and market insights from our team of experts.


Current Issue | December 20, 2018

Income Tax Planning with Family Entities – The Quest for Basis Step-Up

By: Julia Weaver, J.D., Director, Family Office Services and The Trust Company of Oxford

For families who have implemented sound estate planning strategies that include Family Limited Partnerships and Family Limited Liability Companies (LLC's), the goal is typically for consolidation of family investments, diversification of assets, spousal and creditor protection and family control of assets. In addition to these business purposes, another goal may be the strategic creation of restricted interest for Federal Estate Tax (FET) planning purposes.

Often times, a portion of the entity interest is structured as non-controlling, non-marketable and/or non-transferrablei. These restrictions are designed to reduce the valuation of interest, thereby utilizing less of the taxpayer's coveted federal estate tax exemption upon transfer by gift or through the senior family member's (the "Senior's") gross estates upon deathii. This enables more overall wealth to be transferred to heirs, free of estate taxation.

Reconsidering the Desirability of Valuation Discounts (In Some Cases)
At the risk of stating the obvious, the increase in the Federal Estate Tax (FET) exemption from $1 Million in 2003 to $5.45 Million in 2016 has resulted in many families being relieved of this onerous tax. The focus for these families is squarely upon income tax planning.

The Internal Revenue Code provides that assets owned by a decedent at death are entitled to a "step-up" in basis to the asset's fair market value (FMV) on the date of death. Consequently, when the value of an asset is reduced by valuation discounts, the basis step-up potential is equally reduced. The basis received by heirs will, by definition, be less than the FMV of the underlying assets held by the entity. As such, should the heir liquidate interest after Senior's death, the heir must recognize that difference as gain for income tax purposes.

By way of example, assume Senior held assets in an entity that would otherwise be valued at $1 Million dollars. Assuming restrictions resulted in a valuation discount of 35%, the value includable in the Senior's gross estate would be only $650,000, which then becomes the heir's basis in that interest. Assume further the entity provided the heir an option to liquidate the interest after the death of Senior. Upon such liquidation, the restrictions (and therefore the discounts) would no longer apply. Thus, the heir would realize gain in the amount of $350,000.

If the heir was in a marginal tax rate of 39.6%, and thus a capital gains tax rate of 20% (and upon which the 3.8% NIIT would also apply), the federal income tax alone would be $83,300. Any state capital gain tax would also apply, further exacerbating the income tax impact on the heir.

Strategic Planning to Maximize Basis Step-Up
Reducing or eliminating discounts, however, does not necessarily mean taking an atom bomb to the entity. Interest still held by Senior may be restructured in order to eliminate restrictions on control, marketability or transferability.

Amending Entity Documents

Valuation discounts can be eliminated by amending entity documents to enable members to withdraw their pro rata share of entity assets upon the giving of notice to the entity. Conceivably, this access to assets would undermine the IRS requirements for valuation discounts.

These revisions would, however, also negate the asset protection features of the entity. As such, other planning techniques, such as certain trust strategies, should be considered to shore up creditor and divorce protection strategies. The foregoing would, however, enable the entity to remain an ongoing vehicle for investment management and financial education for future generations.

Partial Liquidation

Another option would be to partially liquidate Senior's interest, while otherwise maintaining the entity and the advantages it bestows upon heirs, such as divorce and creditor protection. The liquidation of Senior's interest would result in a portion of the low basis assets being shifted back to Senior's gross estate for step-up potential. Such a distribution would typically be tax free to Senior (since partnership income has already passed through to the partners for tax purposes)iii.

Re-Visiting the Objectives of a Gifting Strategy
There are many factors that support gifting to future generations besides purely tax driven motives (heir education, supplemental income, support for special needs children and estate equalization come to mind, just to name just a few). However, when FET planning is no longer a primary focus, the goals and objectives of a gifting strategy should be revisited. A family that does not have federal estate tax exposure will save more tax dollars by retaining all assets in Senior's gross estate at the highest possible valuation (thereby maximizing the advantage of the basis step-up).

Combining Basis Planning With FET Planning for Maximum Tax Savings
While FET planning and income tax planning are, at times, mutually exclusive, these two planning objectives can also be used in collaboration to enhance the overall result of comprehensive tax planning. For families with significant ongoing FET exposure, tax basis planning can be highly impactful to minimize the income tax exposure of future generations.

A strategy for such families may include utilizing asset swapping powers contained within certain types of trusts. Many trusts include "Powers of Substitution" that can be used for this type of strategic planningiv. Low basis FLP / FLLC interest in such a trust may be substituted out of the trust and back into the taxpayer's gross estate for step-up opportunity. High basis assets should be substituted in to the excluded vehicles, because they would not meaningfully enjoy the advantages of the basis step-upv.

Notably, any previously completed gifts are irrevocable. However, existing strategies should be assessed to determine whether the gifting strategy should be continued, abandoned, and in some cases restructured as herein described in order to maximize any basis step-up opportunities.

Proactive Basis Planning with Partnerships
Much of the new frontier of income tax planning involves the intersection of estate planning with age old accounting principles relative to partnerships. Why partnerships? A partnership is the only form of entity that enables non-pro rata distributions and, albeit with many restrictions and regulations, the internal shifting of basis to specific assetsvi.

First, to give some context to the tax advantage of this strategy (and, admittedly, with the detail of a crayon drawing of the Mona Lisa), consider the following scenario. At a minimum, we plan for at least $10.9 million (for 2016) in value of assets to pass by gift or through the gross estates of a married Senior generation. In this manner, we effectively utilize the full FET exemption.

If we were able to shift all zero basis assets into this $10.9 million bucket, then upon the death of the Senior generation, $10.9 Million in taxable gain would be eliminated and the heirs would now have a freshly stepped-up FMV basis. If Senior's heirs were subject to the 20% capital gains tax rate (with NIIT of 3.8%), this strategic planning could result in a federal income tax savings (to the heirs) of $2,594,200.

This is potentially quite impactful planning. By utilizing these complex mechanisms, and assuming certain critical tax elections have been madevii, planners seek to strip basis from certain entity assets that, by design, are then distributed in-kind out to Senior during Senior's lifetime, with zero basis. Such assets then receive a windfall of basis step-up when the asset passes at death to Senior's heirs. The stripped basis is then reallocated to assets remaining inside the partnership.

Mixing Bowls and Caveats
With every highly impactful tax planning strategy comes the opportunity for abuse and, hence, the scrutiny of the IRS. The "Mixing Bowl" transaction rules are one such anti-abuse provision. This rule is designed to prevent partners from using partnerships as a "mixing bowl" of tax attributes, wherein partners enter into a partnership simply to shift various tax benefits to one another and then liquidate the partnership, with a resulting overall loss in tax dollars to the IRS. As such, the IRS requires that a seven (7) year period must lapse before contributed property can be distributed out to any other partner without recognizing a taxable gainviii.

In other words, this is a long-term planning strategy that requires a minimum period of seven (7) years for implementationix. Patience, however, (and a high appetite for complex planning) can be greatly rewarded in this circumstance.

Collaboration for Optimal Results
The strategies discussed herein illustrate the advantages of an annual review of your overall wealth plan. According to Oxford's Managing Director, Karen Mersereau, CPA, CFP, "partnerships and LLCs are very flexible tools used by families in a myriad of ways to achieve their legacy goals while minimizing income and estate taxes."

Karen also cautions of the need for thoughtful collaboration when considering any new planning strategy, noting that
"these [partnership and LLC] strategies are complex and require close collaboration between your team of advisors, particularly with your CPA." Your Oxford team of advisors look forward to developing a plan for the ongoing review of your gifting strategies and for opportunities to enhance the impact of your current wealth plan.

The facts of this article are based on the Code in effect as of 7.01.2016 and are subject to change. Contact your professional advisors for recommendations tailored to your specific circumstances.

iNotably, the primary purpose of such an entity must be for valid business purposes, the subject of extensive case law beyond the scope of this article.

iiThe Federal Estate Tax Exemption for 2016 is $5.45 Million per person / $10.9 Million per married couples, above which all wealth is taxed at the rate of 40% upon any non-marital transfer.

iiiAn exception would be when a cash distribution exceeds the partner's basis in their partnership interest (as distinguished from the basis of the underlying assets). IRC 731. Other exceptions apply to partnerships holding only marketable securities. A pro-forma of all potential tax impact should be performed prior to executing on any such strategy.

ivIRC 675(4) provides that a trust is a grantor trust for income tax purposes if any person holds a power "in a nonfiduciary capacity…to reacquire the trust corpus by substituting other property of an equivalent value." The retained power to substitute assets of equivalent value will not prevent the grantor from having made a completed gift and will not trigger estate tax inclusion under IRC Section 2038. Exercising the power in a non-fiduciary capacity, means without the approval or consent of any person in a fiduciary capacity (i.e. the Trustee). All that is required is for the Grantor to substitute other property of an equivalent value. The only authority the Trustee has is to use diligence to ensure that property of equivalent value is substituted for the reacquired property, or to make sure to the extent the trust receives unproductive property in place of productive property, if there is an income beneficiary, convert the swapped asset to productive property to the extent feasible.

vThis logic could be usurped by an expectation of significant future appreciation which may result in FET exposure, whereby the benefit of freezing such future appreciation may outweigh the income tax advantage described herein.

vi"Substantial economic effect" is required for basis allocations, the requirement for which are set forth in Treas. Reg. Sections 1.704-1(b)(2), and include specific language requirements for the partnership agreement with respect to maintenance of partnership capital accounts. Further detail is beyond the scope of this article.

viiSee, generally, IRC 743 and 754.

viiiIRC 704(c)(1)(B)

ixAnother such anti-abuse provision is the "Disguised Sale Rule", wherein any partner who contributed appreciated property and received back cash or other property within two (2) years will be "presumed" to have "sold" the asset to the partnership and will therefore recognize gain.