Client Scenarios for Enhancing Business,
Tax, & Estate Planning Goals
The following client scenarios are examples of the types of high-end strategies and comprehensive plans used by the Lukinovich APLC Firm, in order to illustrate to our existing and prospective clients (and to our legal, accounting, insurance and financial advisory referral colleagues in our estate planning community), how we can work imaginatively together with them to implement and enhance business, tax, and estate planning goals for our clients and their businesses and families. These client scenarios generally are based upon actual case studies and plans developed and implemented for our clients, but actual names and circumstances have been changed, and fact patterns of separate clients combined, in order to preserve maximum client confidentiality.
IRS CIRCULAR 230 DISCLOSURE
To insure compliance with Treasury Regulations (31 CFR Part 10, Section 10.35), we are required to inform you that any tax advice contained on this website, was not intended or written by us to be used, and cannot be used by you or anyone else, for the purpose of avoiding penalties imposed by the Internal Revenue Code or other law or for the purpose of marketing or recommending to any other party any transaction, arrangement or other matter. If you desire a formal opinion on a particular tax matter for the purpose of avoiding the imposition of any penalties, our firm must be engaged for that purpose and we will discuss further the Treasury requirements that must be met and whether it is possible to meet those requirements under the circumstances, as well as the anticipated time and fees involved.
CLIENT SCENARIO NO. 1
Building a Lasting Estate, Benefiting Family & Community
Our clients, Sloe and Steddy Smith, are the owners of a third-generation wholesale company, Tortoise Rockying Chairs, Inc. (“Tortoise”) which has been prospering for nearly one hundred years. Over the last decade, Sloe and Steddy have established multi-generational grantor trusts for the benefit of their seven children and the future children and grandchildren of their seven children (i.e., their future grandchildren and great-grandchildren). As a result of this planning and the extraordinary growth of Tortoise (which is taxed as a sub-chapter “S” corporation for federal income tax purposes) over the last seven years, 98% of the stock in Tortoise has been transferred to the multi-generational trusts pursuant to a part gift and part sale estate planning strategy. Recently, the multi-generational trusts received from the family CPA financial statements indicating the trusts have a net worth of $50 million and still owe Sloe and Steddy promissory notes in the amount of $5 million in the aggregate. Unexpectedly however, Tortoise received an offer from a strategic buyer, Fast and Furious Hares, Inc. (“Fast and Furious”), that is trying to execute a rollup of certain manufacturing companies in the Southern United States. Fast and Furious has offered Tortoise an all cash purchase price of $75 million which will result in a combined federal and state income tax of approximately $10 million; Sloe and Steddy, as grantors of the multi-generational trusts, will remain responsible for the $10 million tax liability on the sale of stock of Tortoise.
We reviewed with Sloe and Steddy their personal balance sheets, which consist of assets valued at $25 million, including the $5 million of promissory notes owed to them by the multi-generational trusts. Once the sale is consummated, the multi-generational trusts will have cash assets of $70 million after satisfying the notes payable to Sloe and Steddy. It is evident that Sloe and Steddy accomplished a tremendous benefit from the prior estate planning implemented by them which will fully be realized when Tortoise is sold to Fast and Furious.
Now that Sloe and Steddy have successfully accomplished their estate planning, they realize that they already have utilized all of their federal estate tax lifetime exemption amounts and still have a taxable estate in the neighborhood of $15 million after payment of the taxes on the sale of Tortoise. Of the $15 million in assets, $10 million constitutes Sloe’s separate property and $5 million constitutes Sloe and Steddy’s community property. One benefit of the prior estate planning is that Steddy is the primary income beneficiary of one-half of the multi-generational trusts and, therefore, will be taken care of for the rest of her life.
Sloe and Steddy desire to accomplish one more objective as a final part of their estate planning; at the death of the second of Sloe and Steddy to die, they desire to leave $5 million of their community property to a community foundation to perpetuate the stewardship that they engaged in during their lives, and they would like for their seven children to participate as donor advisors to the community foundation in order to carry out the philanthropic goals of Sloe and Steddy well after they have left this world.
Even though Steddy will be taken care of from income distributions of some of the multi-generational trusts, Sloe would like to enhance his cash flow to maintain his lifestyle (particularly in the event Steddy predeceases him and the community no longer receives income from the trusts), but at the same time Sloe wants to make sure that his heirs are not left with a $4 million estate tax bill (i.e., $10 million x 40% estate tax rate) at the time of his death. Accordingly, Sloe who is 70 years old and has $10 million of separate property (substantially all of which constitutes high basis stock and a bond portfolio) has decided to sell his $10 million portfolio to the multi-generational grantor trusts created by him; this sale can be accomplished on a tax free basis, because the trusts established by him are grantor trusts for federal income tax purposes. The sale by Sloe will be to the trusts in exchange for a lifetime private annuity payable to Sloe based on an Internal Revenue Code §7520 interest rate of 2.20%. The private annuity annual payment due to Sloe will be approximately $857,000 which is quite a bit greater than his current return on his portfolio assets. However, under the current estate plan, Sloe and Steddy will continue to be taxed on the income generated by the multi-generational grantor trusts for the remainder of their lives. Assuming that Sloe and Steddy consume any income generated by their community property and that Sloe will receive $857,000 of annuity payments from his multi-generational grantor trusts each year, the couple can further reduce their estate tax exposure by using that income stream in several ways.
First, Sloe estimates that he will pay approximately $400,000 annually on taxable income (some amount of tax on the interest portion of the private annuities and the balance generated by the multi-generational grantor trusts as long as those trusts are maintained as grantor trusts and not converted to non-grantor status). After payment of this $400,000 of taxes, Sloe is left with $457,000 of disposable cash flow, and to the extent that Sloe and Steddy do not consume this disposable income by charitable donations and personal consumption, they can also deplete their estates by $196,000 per year by making $14,000 of annual donations each (i.e., $28,000 for the two of them) to their seven children. The remaining disposable annual cash flow is approximately $261,000, giving them approximately $21,750 per month in spending money not counting their social security, income from community property and any distributions to Steddy from the multigenerational grantor trusts. In the event that their cost of living increases or taxable income generated by the multi-generational trusts increases, Sloe and Steddy can reduce the gifts to their children or decrease the amount of lifetime charitable giving that they make to their favorite charities.
As a result of this supplemental estate planning, Sloe and Steddy have figured a way to: (a) zero out their federal estate tax liabilities at the time of their deaths, (b) create tremendous wealth for their descendants, and (c) provide significant charitable resources to various community charities.
CLIENT SCENARIO NO. 2
Strategic Restructuring for Magnificent Machines: Optimizing Tax Efficiency & Family Succession
Patriarch and his two sons have been operating a machine shop for the past 30+ years. Patriarch & Matriarch, in addition to having two sons in the business, have a daughter who only works part-time in the business. Over the last few years, their machine shop business, Magnificent Machines, which had been operated as a “C” corporation, has experienced tremendous growth and income well beyond the dreams of Patriarch’s family. During a recent family meeting, we explained that they are out-growing the “C” corporation status, particularly because they are having to pay larger and larger salaries to the family members in order to reduce the federal and state taxation on the corporate level of income. The Patriarch family is also becoming concerned that the level of compensation may be greater than what would be acceptable as reasonable compensation, particularly if the success of Magnificent Machines continues. Patriarch asked that we assist them with the following goals:
Convert Magnificent Machines to Subchapter “S” status to avoid double level taxation and to mitigate the employment taxes payable on salaries and bonuses currently paid to family members in the future as the Company generates more and more taxable income;
Provide reasonable cash flow to their daughter who is not working full time in the business;
Recapitalize the corporation to provide voting and non-voting stock so that non-voting stock can be donated by Patriarch to his daughter (to provide distributable profits to her) and by Patriarch’s two sons to their own children, who are active in the business, in order to incentivize Patriarch’s grandsons who are working in the business.
Evaluate the relationship between Patriarch’s real estate holding company and Magnificent Machines to ensure that leases are at fair market value and tax reporting is appropriate for the rental activity.
To accomplish the goal and objectives set forth above, Magnificent Machines has been recapitalized so that Patriarch’s ownership is comprised of 1% voting shares and 99% non-voting shares. Patriarch has decided to donate to his daughter 10% non-voting shares of Magnificent Machines and a larger portion of his voting and non-voting shares to each of his two sons so that the two sons end up with 100% of the voting control of Magnificent Machines. Patriarch’s daughter ends up with 10% non-voting stock allowing in her to receive 10% of cash distributions made from cumulative earnings of Magnificent Machines.
The two sons can incentivize their children that work in the business and engage in their own estate planning by donating to them a portion of the non-voting stock of Magnificent Machines. As more and more stock is transferred to Patriarch’s grandchildren who are working in the business, a remarkable amount of income tax savings will be achieved as more “S” Corporation income is taxed to the grandchildren who are in lower tax brackets.
Careful planning is required to minimize the impact of the additional 3.8% net investment income tax that began in 2013. Patriarch and his children have decided to contribute all of the commercial real estate used in the business into a limited liability company which will lease the real estate and buildings to Magnificent Machines at fair market value. To the extent the rental income is derived from rental of property to the operating business in which each taxpayer participates, the otherwise passive rental income will be characterized as non-passive income and thus avoid the additional 3.8% tax. By transferring some of the ownership in the real estate holding company to younger family members (i.e., Patriarch’s grandchildren) who are not involved in the business operations of Magnificent Machines, Patriarch can supplement the income of those children and shift taxable income to their lower federal and state income tax brackets. Also, the additional 3.8% net investment income tax on passive rental income will be avoided where each grandchild reports total income below the applicable threshold (AGI of $200,000 for single filers and $250,000 for married couples).
CLIENT SCENARIO NO. 3
Building a Legacy: Tax Efficiency & Succession Planning for Grand Slam Holdings
Home Run Joe and his wife, Josie, have knocked it out of the park in the development of their retail business, which now is operated at six locations. Over the last 15 years, Home Run Joe and Josie have engaged in estate planning resulting in 75% of their holding company (“Grand Slam Holdings” which owns the operating businesses) being held in multi-generational grantor trusts for benefit of their three sons and the current and future descendants of their sons. One of the goals that Home Run Joe and his family have had over the years is to expand the retail outlets of the business in order to provide a living for all three branches of the family as their family grows.
As a result of the prior planning by Home Run Joe and his family, Grand Slam Holdings now generates over $2 million of taxable income to Home Run Joe and his wife, Josie, excluding salaries that they take from the business. In addition to owning the operating businesses, Grand Slam Holdings also owns a subsidiary real estate holding company that holds title to the real estate used by the business. Now that Grand Slam Holdings is owned 75% by multi-generational grantor trusts for the benefit of their descendants, Home Run Joe and Josie are paying a significant amount of federal income and state income taxes because of their high marginal income tax brackets and substantial annual business income.
Home Run Joe and Josie met with us to request that we analyze their current structure and advise them on how they might mitigate federal and state income tax, particularly now that all three sons are managing various retail outlets of the business. Since 75% of Grand Slam Holdings is now owned in the multi-generational grantor trusts, which has three equal subtrusts for each of Home Run Joe’s and Josie’s three sons and their descendants, we recommended that the trustees of the multi-generational grantor trusts consider making a distribution of 10% of the ownership of Grand Slam Holdings to each of the three sons. As a result of this plan, each of the sons will receive distributable income from the holding company of approximately $200,000 annually (i.e., $2,000,000 x 10%) in addition to their current salaries of approximately $75,000. By shifting this income out of the multi-generational grantor trusts, Home Run Joe’s and Josie’s income will be reduced from $2 million to approximately $1.4 million not counting salaries payable to them for their services to the business.
It is estimated that the income tax savings resulting from this shifting of the income to lower tax brackets, will result in a tax savings of nearly $90,000 per year. A portion of these tax savings will be maintained by Grand Slam Holdings in order to further expand the business. Some of the tax savings will be distributed to the three sons to enable them to establish and fund insurance trusts for the benefit of their families. Because Home Run Joe’s and Josie’s planning has resulted in substantial family assets passing into multi-generational trusts solely for the benefit of their descendants, their three sons want to acquire life insurance to protect their spouses, who are not beneficiaries of the multi-generational trusts.
The plan implemented for Home Run Joe and Josie and their descendants has accomplished their objectives of: (a) preserving the family business for their current and future descendants, (b) mitigating estate and income taxes, and (c) creating a management structure that allows the three family branches to perpetuate the management of the business by naming future managers of Grand Slam Holdings as well as future managers of the various retail outlets that are maintained in separate subsidiary entities.
CLIENT SCENARIO NO. 4
Maximizing Wealth Transfer: A Comprehensive Business & Estate Plan for Elder and Younger
“Elder” and “Younger” are two brothers engaged in a cyclical business (“CB”) that tends to have growth spurts every four to five years. CB has been an “S” corporation for over 10 years.
During the fourth straight flat year, Elder became a client of our firm; and we learned, when ascertaining Elder’s estate planning goals and objectives, that Elder is a widower who has a net worth of approximately $25 million, $20 million of which constitutes his undiscounted 50% ownership of CB. Elder indicated that he was content with living on $20,000 per month after tax dollars, but was concerned that, at his death, the federal estate tax could cut his net worth nearly in half and reduce the amount that would pass at his death for his family. Elder’s wife, who died three years prior to our engagement, was survived by two adult children and several grandchildren, and left her community interest in Elder’s 50% interest in CB outright to Elder, resulting in Elder having a tax basis of $13 million in his CB stock due to a step-up in tax basis at the time of the death of Elder’s wife.
After Elder indicated that he would be interested in selling the CB business during its next spurt in value: first, we drafted documents to recapitalize CB ownership into separate 4% Voting Stock and 96% Non-Voting Stock (one half of the Voting and Non-Voting Stock owned by each of Elder and Younger) while maintaining CB’s status as an S Corporation; second, we drafted a multi-generational “Grantor Trust” (the “Elder Family Trust”) that Elder executed as settlor, containing equal subtrusts for Elder’s two children and their current and future grandchildren (i.e., Elder’s future great-grandchildren); and, third, we drafted installment sale documents whereby Elder sold his 48% Non-Voting stock to the Elder Family Trust (24% to each subtrust) in exchange for installment notes payable over a nine-year period using a 4% applicable federal mid-term interest rate then in effect. Elder retained 2% of the stock constituting one-half of the Voting Stock of CB. We worked with appraisal colleagues in order to obtain separate appraisals, first of the CB business as a whole, and second, of the 24% minority nonmarketable Non-Voting interests sold to each subtrust. The sales price was $6,240,000 for each 24% block of stock determined by the appraisals (i.e., $40,000,000 total value of CB x 65% discounted value (35% combined discount for lack of marketability and minority interest) = $26,000,000 x 24% block of stock = $6,240,000).
Certain provisions that we included in the Elder Family Trust resulted in making the Elder Family Trust a “Grantor Trust” for federal income tax purposes, with the following results desired by Elder: his sale of 48% of his Non-Voting stock was ignored for capital gains tax purposes; his receipt of 4% interest on the installment notes also was ignored for income tax purposes; and he continued to be liable for all income taxes due on the Trust’s net income, thereby allowing 100% of the Trust net income (before income taxes) attributable to 48% of CB to pass for the benefit of the Trust beneficiaries free of income tax, in accordance with Elder’s goals to transfer wealth to his descendants in a tax-efficient manner.
During the next two years following the installment sale, CB began another growth spurt and produced enough distributable income to enable CB to make prorata distributions sufficient for the Elder Family Trust to pay principal and interest on the installment notes.
At the end of the two-year period, Elder was able to convince Younger that they should sell CB to a venture capital group at a premium price of $100 million, enabling Elder to realize his dream (full retirement) and Younger his separate dream (becoming the CEO of an expanded CB that would receive a capital infusion by the venture capital group to acquire several similarly situated businesses).
Upon the sale of CB nearly nine months later, the Elder Family Trust received $48 million of sales proceeds and paid Elder the balance owed to him on the two installment notes of approximately $11.5 million, resulting in the Elder Family Trust retaining $36.5 million of investible cash for the benefit of Elder’s descendants, virtually all of which will be excludible from the taxable estates of Elder’s children and grandchildren (at the time of their deaths) and protected from the creditors of Elder’s descendants.
Elder received $2 million from the sale of his 2% Voting Stock and $11.5 million from the full payment of the installment notes, for a total of $13.5 million from the sale of CB. Moreover, because the Elder Family Trust was structured as a “Grantor Trust” for federal income tax purposes, Elder was responsible for paying the federal capital gains tax on all 50% of the stock held by him and the Elder Family Trust, in the aggregate amount of $7.4 million (i.e., $50 million sales price less $13 million tax basis (or $37 million) x 20% combined federal and state tax rate = $7.4 million) resulting in Elder netting $6.1 million from the sale of CB (i.e., $13.5 million – $7.4 million in taxes).
If Elder had not established Elder Family Trust and sold to the Trust 48% of CB prior to the sale of CB, then his estate would have contained an additional $36.5 million in value. Instead, $36.5 million net proceeds was retained in the Elder Family Trust because of our comprehensive business and estate plan, excludible from his estate (and from federal estate tax) at his death.
Assuming a 45% federal estate tax will apply at Elder’s death, the $36.5 million value removed from his estate will result in federal estate tax savings of $16.425 million (assuming current rates). Additional potential federal estate tax savings result from: excluding from federal estate tax any appreciation from Family Trust reinvestments of the $36.5 million net proceeds until Elder’s death; and also excluding from federal estate tax any non-distributed Family Trust assets upon the eventual deaths of Elder’s children and grandchildren. If invested successfully, the $36.5 million of Elder Family Trust assets should continue to grow and produce additional value that will escape federal estate taxation until the death of Elder’s future great-grandchildren.
Elder was left with a net worth of approximately $12 million. He determined that he was satisfied with this net worth since he only needed a two (2%) percent after tax return to provide him his desired $20,000 per month after tax living expenses (i.e., $12 million x 2% = $240,000 ÷ 12 months).
Finally, we drafted a new Will for Elder to execute, following his desire to leave the portion of his estate exceeding his federal estate tax exemption to his charitable Foundation at the time of his death. We worked with him to establish a Foundation during his lifetime, to obtain tax-exempt status for the Foundation, to establish by-laws and desired charitable purposes, and to name a governing Board of Directors, that will include his two adult children and, eventually, their descendants so that his family can continue to benefit Elder’s community long after Elder’s death (while still retaining significant family wealth in the Elder Family Trust).
CLIENT SCENARIO NO. 5
Preserving Family Wealth: A Strategic Estate Plan for Chief Menteur & the Future of the National Franchise
Our client, “Chief Menteur,” is the owner and chief operating officer of a well known national franchise (“NF”) that has a fairly consistent annual growth in value of approximately 12% although the franchise does not produce significant cash flow. When Chief came to our firm seven years ago, NF had a fair market value of $70 million. Chief used most of his after tax cash flow to support himself, his wife and his five children in a fairly comfortable lifestyle. Chief’s biggest concern was that none of his children had any interest in becoming the successor CEO or continuing to own and operate NF. Considering his children’s lack of relevant business education and experience, the franchise agreement was so restrictive that it was uncertain whether any of Chief’s children would be permitted to continue to operate the business after his death, even if one of them desired to do so.
Chief expressed three other concerns. First, because of the illiquidity of NF, he was concerned that his estate would have insufficient cash to pay the federal estate taxes due nine (9) months after the death of the last to die of himself and his wife. Second, Chief was concerned that his children would be left with too much disposable wealth after the death of his wife and himself, and concerned that spouses and future spouses of his children may become too entangled in family wealth that he wanted to leave for the benefit of his children. Third, although NF was a national franchise, Chief had earned a substantial percentage of his wealth from a certain geographic area of the United States and desired to leave a substantial portion of his net worth to one or more community foundations in that geographic area.
After analyzing Chief’s goals and objectives, our firm worked with a group of insurance consultants who were able to obtain agreements with various insurance companies for the issuance of several second-to-die life insurance policies on the lives of Chief and his wife. The policies had an aggregate death benefit of $40 million, in order to fulfill Chief’s desire to leave $8 million for the benefit of each of his five children (and ultimately their future descendants). Because of the health of Chief’s wife and her below-average life expectancy, Chief expected to survive his wife and had no desire to sell NF until after his death.
The $40 million of life insurance was acquired in a Delaware dynasty trust (the “Chief Family Trust”) that we drafted. Chief and his wife funded the Chief Family Trust with a lump-sum donation of $2.0 million, fully utilizing their respective $1.0 million federal lifetime gift tax exemptions.
Our firm also worked in implementing a deferred compensation plan for a younger key employee to acquire a minority interest in NF, and a buy-sell agreement for the installment purchase or redemption of the NF shares owned by Chief and his family, or trusts therefore, after Chief’s death. We also worked in negotiating a base price established by formula, and a contingent additional purchase price dependent upon future profits after sale.
Both Chief and his wife executed Wills that we also drafted to satisfy their estate planning goals. Chief’s wife, in her Will, left to Chief her interest in NF. The Wills provided that a testamentary charitable lead trust would be established under the Will of the surviving spouse, leaving the residuary estate of the surviving spouse in trust with their five children as remainder/principal beneficiaries. The Chief Family Trust was drafted broad enough to allow it to purchase assets from the estates of Chief and his wife including the remainder interests in the testamentary charitable lead trusts. The lead beneficiaries of the charitable lead trust are three separate community foundations located in the geographic area, earmarked by Chief. Chief’s descendants are designated as the family advisors for each of the community foundations.
The Wills included formula clauses to reduce to zero (“zero-out”) the value of the remainder/principal interests of the charitable lead trust created on the death of the second to die of Chief and his wife, so that no federal estate tax will be due upon the death of the second spouse to die.
Provided that NF is sold and that the proceeds from the sale of NF produce a sufficient investment return to satisfy the charitable lead payments to the community foundations for the time period necessary to zero out the value of the remainder/principal interests (anticipated to be 25± years), then at the end of the charitable lead period Chief’s descendants will have some “lagniappe” in addition to the $40 million of insurance proceeds payable to the Chief Family Trust upon the death of the second to die of Chief and his wife.
During the existence of the charitable lead trust and the payments to the community foundations, Chief’s descendants will enjoy the ability to designate funds for distribution by the community foundations to continue benefiting Chief’s charitable beneficiaries.
CLIENT SCENARIO NO. 6
Expanding Generational Wealth: Phase II of Chief Menteur’s Estate Plan with Rolling GRATS
Three years after completing the original estate plan for “Chief Menteur” (under Client Scenario No. 2, above), Chief had his sixth grandchild and had a change of heart regarding the size of the inheritances he wanted to leave to his children and their descendants.
With the birth of six grandchildren in three years and the expectation of many more to come, Chief met with our firm to engage us to assist him with new Phase II of his estate planning, consisting of his new desire to increase the assets he and his wife wanted to provide for the benefit of his children and grandchildren.
As set forth in Client Scenario No. 2, the Chief Family Trust was established as a multi-generational dynasty trust for the benefit of his children and their descendants for many future generations. Although the Chief Family Trust provided for priority distributions to Chief’s children, the trust instrument that we drafted clearly gave guidance for the trustees not to over-endow Chief’s children in a way that potentially would thwart their incentive to become productive citizens, and for the trustees to consider all other resources available to the children (including their income-earning capacity) before depleting the income and/or principal of the Chief Dynasty Trust.
We discussed with Chief and his wife several alternative estate plans involving their establishing Grantor Retained Annuity Trusts (“GRATS”) for their NF stock.
Using GRATS is another technique designed to preserve family wealth by reducing gift taxes on the transfer of assets for the benefit of children. The present value of the GRAT remainder interests passing for the benefit of children (the interest remaining after paying the stipulated annuity to the settlors) is subject to gift tax upon creation of the GRATS, but such gift tax value can be “zeroed-out” if the annuity is set at the full present value of the contributed NF stock. Generally, for tax reasons, children (and not grandchildren or more remote descendants) should be the GRAT remainder beneficiaries; and using GRAT assets for the benefit of children for their remaining lifetimes (after making the stipulated annuity payments to the settlors) would allow the dynasty trust assets to be used solely for the benefit of younger generations.
If a settlor dies during the retained annuity term (that can be 2, or 5, or 10 years, or other stipulated term during which an annuity will be paid back to the settlor), then some or all of the trust’s assets will be included in the settlor’s gross estate. However, if the settlor is living when the final annuity is paid, then the trust remainder interest passes to or for the benefit of children free of further transfer tax.
We consulted with colleagues and provided several different models to Chief and his wife, using various assumptions of assumed future fluctuations in value and yield of the NF stock, chances of mortality, etc., in order to discuss with them the relative advantages and disadvantages of using different annuity terms (including the increased risk of a settlor dying during a longer retained term, with resulting adverse federal estate tax consequences). The GRAT annuities could be paid with cash or with part of the NF stock held in the GRAT, valued at a (presumably) higher value on the date when the annuity is due. Chief advised that the NF stock should continue to appreciate and generate income.
After discussion and review of our models, Chief and his wife decided to establish 2-year “rolling” GRATS rather than a longer-term GRAT. “Rolling” GRATS refers to the settlors using received annuity payments (hopefully in a smaller percentage of the closely-held business interest contributed to the GRAT, as a result of ongoing appreciation) that the settlors use to establish new 2-year GRATS.
We proceeded to implement Phase II of Chief’s estate plan.
First, in order to achieve desired tax benefits, we drafted an agreement whereby Chief and his wife partitioned the community NF stock so that each of them thereafter would hold one-half of their NF stock as his or her separate property.
Second, Chief and his wife each created five separate GRATS for each of their five children and transferred 10% of the NF stock to each GRAT, with the result that 100% of their NF stock was transferred to GRATS. The GRATS were established when the Internal Revenue Code Section 7520 assumed rate of return on investments was historically low (4%), with the result that it became easier for the GRAT assets to outperform this IRS assumed rate of return, and thereby have greater value remaining for children after payment of the annuities. Additionally, it was easier for the GRAT assets to outperform this IRS assumed rate of return because, with the assistance of appraiser colleagues, we helped to establish a discounted value for the 10% minority NF interests transferred to each GRAT. At the time the GRATS were established, the NF stock had an undiscounted value of $100 million and each 10% block of stock had a discounted value of $6.5 million (i.e., $100 million x 65% discounted value x 10% block of stock).
At the end of Year 1 and Year 2, the GRATS made annuity payments of NF stock in kind to Chief and his wife in the aggregate amount of approximately $35 million each year for a total of $70 million of NF stock on a discounted basis.
At the end of Year 2, the GRATS after payment of 2 annual annuities payments had an aggregate remaining value of $7.3 million of NF stock on a discounted basis ($11.2 million of NF stock on a non-discounted basis). The $35 million of discounted NF stock paid to Chief and his wife (in the aggregate) at the end of Year 1 was rolled into a second set of GRATS and the $35 million paid to Chief and his wife in the aggregate at the end of Year 2 was rolled into a third set of GRATS.
Four years after initiating Phase II of Chief’s estate plan: the first set of GRATS contained approximately $14 million in undiscounted NF stock for the benefit of Chief’s children; the second set of GRATS contained approximately $4.2 million in undiscounted NF stock for the benefit of Chief’s children; the third set of GRATS had approximately $3.8 million of undiscounted NF stock in the aggregate; and, together, the three sets of GRATS held an aggregate undiscounted value of a little more than $22 million in value for the benefit of Chief’s five children. Actually, the transfer benefits were greater; less NF stock had to be paid back to the settlors as annuity payments because of interim appreciation in its value, and greater value remained for the benefit of Chief’s five children.
The Phase II estate plan continues with rolling GRATS executed annually by Chief and his wife, effecting the transmission of a tremendous amount of value from Chief’s and his wife’s estate without the use of cash. Furthermore, the GRATS each roll into separate remainder trusts for the benefit of Chief’s children, established for the life of each child, so that these vehicles can continue to be used by the trustees for future investment opportunities.
CLIENT SCENARIO NO. 7
Building a Legacy: Multi-Generational Planning & Family Limited Partnerships in Real Estate Development
Four brothers, “Joel, Jeff, Jesse and James,” operate a real estate development business. For many years, each new project was capitalized by each brother contributing $250,000 as seed money for a new development with institutional borrowing used to fund the balance of capital needed.
When the four brothers became clients of our firm, they indicated that they and their wives: (a) were very comfortable with the net worth accumulated by them over the years; (b) had received substantial gifts, and expected to receive substantial inheritances, from their parents and grandparents; and (c) were ready to start sharing opportunities with their own children.
We advised each of the brothers to establish a Family Limited Partnership in the state where they operate their business, with each brother retaining a General Partnership Interest (through a corporation), and naming his respective children eighty (80%) percent limited partners of his Partnership.
Brother Joel had four children, capitalized the Joel Family Limited Partnership with $10,000, and then donated 20% limited partnership interests to each of his four children. Each of the other three brothers did similar planning.
After the Joel Family Limited Partnership was created and capitalized with $10,000, Joel and his wife loaned $240,000 to the Partnership at a long-term applicable federal rate of 6%. The Joel Family Limited Partnership then contributed its $250,000 of cash to the newest family venture (“Newco, LLC”). Similarly, the three other Family Limited Partnerships established by the other three brothers contributed $250,000 each so that Newco was capitalized with $1.0 million and could commence development of its newest venture. The loan made by each brother to his Family Limited Partnership provided for installment payments of interest only (with a single balloon payment in 15 years) so that Newco would have sufficient time to become operational and generate positive cash flow before making substantial distribution to the Family Limited Partnerships for them to repay their loans.
Newco produced a cash flow of approximately 12% on its $1.0 million of capital and a much higher leveraged rate of return on the capital it borrowed. At the end of Year 5, Newco had produced cumulative cash flow of approximately $3,000,000, with the Joel Family Limited Partnership receiving one-fourth of the cash flow distributions or $750,000. From this $750,000, Joel and his wife have been repaid $72,000 of interest on their $240,000 loan to Joel’s Family Limited Partnership. A good portion of the remaining $678,000 ($750,000 – $72,000 interest) of cash flow has been offset by depreciation using cost depreciation (enhanced pursuant to a cost segregation study) with all taxable income being reported by Joel and his wife on their federal income tax returns under the “kiddie tax rules.” The $678,000 of accumulated cash has been used by the Joel Family Limited Partnership to fund three additional developments by Newco II, Newco III and Newco IV with additional capital supplied by Joel and his wife through fairly nominal cash donations to the Joel Family Limited Partnership. We established the Newco ventures as separate LLCs in order to segregate risk, for asset protection purposes.
As a result, Joel and his wife have moved substantial net worth into a vehicle for their four children, fulfilling their additional desire to manage the investment of these resources through the Newco entities, and by having Joel as the General Partner of the Joel Family Limited Partnership.
Additionally, Joel and his wife, together with his brothers and their wives, have established multi-generational trusts for their respective children and grandchildren, which they will begin using for future development opportunities and which will be available to their parents to make generation-skipping testamentary distributions from their estates.
CLIENT SCENARIO NO. 8
Optimizing Assets: Tax Strategies, Diversification, & Legacy Planning for Oil, Gas, & Real Estate Investments
Our married clients, “Olive” and “Earl,” own oil and gas working interests in several states (the “Olive Earl Properties”). Considering escalating oil prices, they desired to liquidate some Olive Earl Properties and reinvest sales proceeds in a more conservative and diversified portfolio, but were dismayed at the level of the joint income taxes they would have to pay on sale since the Olive Earl Properties were owned in a “C” corporation.
We determined that many of the Olive Earl Properties were situated in states having favorable laws treating them as real property interests subject to exchange with real estate investment properties under the Internal Revenue Code Section 1031 “like-kind” exchange rules. Meanwhile, Olive and Earl advised us that, as a result of depreciating real estate values resulting from the subprime lending crisis, they believed that it was a favorable time to invest in diversified real estate investments which they actively would manage and operate. Substantially all of the federal income tax liability realized from selling various of the Olive Earl Properties, except for some recapture, was deferred pursuant to the Code Section 1031 deferred “like-kind” exchange rules.
Meanwhile, when oil and gas working interest sales proceeds were rolled over and reinvested in various other real estate properties, at least until new buying opportunities become available in the oil and gas market (that Olive and Earl currently believe to be overpriced), Olive and Earl have converted their “C” corporation to an “S” corporation to begin the 10-year built-in gains tax period after which they can sell re-investments without “double” tax under the “C” corporation rules.
During the next 10 years, Olive and Earl intend to re-enter the oil and gas market if and when they consider reasonable purchase opportunities exist, or to continue to manage their real estate investments that they consider to be “bargain purchased.”
We discussed with Olive and Earl about whether, ultimately, they want us to work with them to develop an exit strategy for the sale of their closely-held business interests, or instead to leave closely-held business interests to or for the benefit of their children or grandchildren (and, in the latter case, what management and control provisions they want to establish for continued management of these businesses). They are considering their options. Meanwhile, they have executed Wills that we drafted pursuant to their interim desires to leave these decisions to the surviving spouse.
CLIENT SCENARIO NO. 9
Strategic Wealth Transfer: Protecting Assets, Minimizing Taxes, & Nurturing Future Ventures
“Midas Magnificent” had several successful separate businesses, some of which have both a high degree of risk and a concurrent explosive growth potential. Midas, a widower, has three young children and desires to transfer family wealth for their benefit in a manner that: first, can be protected from his and their future creditors; second, can prevent his children from learning the full extent of their financial status (in order to prevent them from becoming “idle-rich jet-setting trust fund babies”); and, third, can be accomplished with reduced adverse tax consequences.
When we met with Midas, he identified, among many separate businesses that he owned, four different closely-held business interests (in totally unrelated industries) which he assured us should be worth twenty times their current values in the next few years. The in-house CPA and in-house attorney for Midas also generally were optimistic about future prospects for these four closely-held business interests, but (not having the entrepreneurial skills or zeal of their boss) did not believe in the future degree of growth for all the businesses. Instead, they believed that any individual business could be destroyed by much larger competitive businesses, or by unforeseen future circumstances in a particular industry, although the success rate of their boss in similar circumstances certainly exceeded 25% even though not quite everything Midas touched turned to gold.
In order to segregate the business risks associated with each venture (each of which was being operated in a separate limited liability company), we advised Midas to establish five separate GRATS, each with three subtrusts for each of his three children, so that he could transfer 75% of his interest in each closely-held LLC to one GRAT, for division and allocation of a 25% interest to each of the three subtrusts thereof. Following this transfer, Midas retained 25% of his former interest in each closely-held LLC.
Midas, after reviewing various alternative GRAT models that we prepared and discussed with him (including discussions about the relative advantages and disadvantages of different GRAT terms, etc., set forth in Client Scenario No. 3 above), directed us to draft GRATS providing for annuity payments back to him for a five-year retained annuity term, with maximum escalating annuity payments and a “zeroed-out” remainder interest. Pursuant to the Internal Revenue Code GRAT rules, GRATS can be established to increase the annuity payment by up to 20% each year during the retained annuity term. Escalating the GRAT annuity payments allows smaller initial payments to be made, and increases the value of the remainder interest, if GRAT assets are outperforming the IRS assumed rate of return (more easily accomplished if the GRAT assets are minority closely-held interests having a discounted value less than their proportionate share of the value of 100% of the closely-held business (valued as a whole).
We obtained independent appraisals for each of the four businesses, as well as for the minority unmarketable interests in each business transferred to each of the three subtrusts of the GRAT established to hold such closely-held business interest.
Each of the GRATS contained a remainder trust for the children that would be kept in existence for their full remaining lifetimes. The in-house attorney and accountant were named as co-trustees, with the settlor retaining the right of removal and replacement with independent non-related and non-subordinate co-trustees.
Because the GRATS and the remainder trusts were established as “Grantor Trusts” for federal income tax purposes, Midas will continue to report all Trust income on his own income tax returns, with two continued desired benefits: first, Midas will be liable to pay all of the income taxes attributable to the Trust income without such payments being treated as taxable gifts to the children beneficiaries of the Trust; and, second, Midas intends to keep his children (and future spouses) ignorant about the Trust assets as long as possible, and to make any distributions solely by having the co-trustees purchase items for the beneficiaries rather than giving Trust checks to the beneficiaries.
The GRAT established to hold one of the four businesses terminated two years after it was established. The business interest held by that GRAT (the defunct GRAT) lost so much of its value that the defunct GRAT had to repay to Midas all of its remaining LLC membership interests therein when the second annuity payment was due, and then dissolve. Since we had established separate GRATS for each of the four businesses, the assets of the other three continuing GRATS were segregated from the assets of the defunct GRAT and were not liable to pay the remaining annuity payments due by the defunct GRAT.
The other three businesses performed extremely well, much closer to Midas’ projections than those of his in-house advisors. Midas, who is taxable on all Trust income and losses, is using the losses generated by the defunct business to offset the income generated by the successful businesses.
Recently, one of these businesses sold for more than ten times the value established upon creation of the GRATS. The trustees are using the sales proceeds to fund new business opportunities to be co-owed by Midas and the trusts.