How to Create and Transfer Discounted Interests
Here we will use the example of a client with appreciated real estate, held in a Limited Liability Company. The value of the property has suffered a substantial decline in value over the past few years but is expected to recover, or has been recently purchased.
Step 1: Create an LLC to provide for two classes of membership, Class A and Class B. Certain restrictions are placed on the transfer of the Membership Interests. For example, Class A may represent 10% of the Profits interests and 100% of the Voting Interests. Class B will represent 90% of the Profits interests and 0% of the Voting Interests. Initially, the client will own all of the Class A Membership Interests and all of the Class B Membership Interests. Because the client owns all of the Class A Membership Interests, the client retains complete management and voting control. The property will be transferred to the LLC. Some or all of the Class B Membership interests will become the subject of gifts, as described below.
Step 2: An Irrevocable Trust (“Trust”) is formed for the benefit of the client’s children and grandchildren. The client names a friendly but not “subordinate” person as the trustee. The Trust will need its own Tax ID and will need to file annual returns. The client will not be able to change the terms of the Trust after it is created, so the client will need to carefully consider what terms they will want to include regarding the assets in the trust – will they pass outright to her descendants or be held for them for some period of time, paying only income, discretionary principal, or other terms. If left in the trust, and only disbursed in the “discretion of the trustee”, the assets can be protected from claims of the descendants’ future creditors and divorcing spouses.
Step 3: The property and the Membership Interests are appraised. Because restrictions have been placed on the Membership interests (for example, they have no voting control), the appraised value may be substantially discounted from what the value would be if there were no restrictions.
Step 4: Class B Membership Interests having a total discounted value of up to $5,000,000 (the lifetime Exemption Amount for 2011 and 2012) are gifted to the Trust this year. The Annual Exclusion of $13,000 per donee may also be used, with the possibility of gift splitting doubling the “per donee” amount. The Trust may be structured with Crummey powers. Depending on how the property is titled, it may be possible to use two $5,000,000 lifetime exemptions.
Step 5: The client’s CPA will need to file a Gift Tax Return and make “adequate disclosure”.
Step 6: In each succeeding year the client can continue the gifting to the Trust, but is not required to do so.
Note that the Trust will receive a “carry-over basis” in the property as the Class B Membership Interests are transferred. Generally, this means that when the property is sold, tax on the gain will be calculated based on the difference between what the client paid for the property and the selling price. However, if the client did not engage in this transaction, and the property were not to be transferred to its descendants until the client’s, the basis would be stepped up to the value at the date of the client’s death (all alternate valuation date) and there would be no gain, and therefore no tax on a subsequent sale at that date of death value. No guaranty is made, of course, regarding future income, estate or gift tax rates or exemption amounts.
The benefit of this structure is that (when properly drafted and documented), if the property currently has a depressed value or was recently purchased, and if it is further discounted because of restrictions imposed on the Class B membership interests, value is transferred out of the client’s estate, and thus would not be taxable in the client’s estate. Further, all appreciation (to the extent represented by the Membership Interests transferred) after the date of the transfer will not be in the client’s estate.
Note that in structuring these transactions, the draftsman must be careful to draft around certain problematic provisions of the Internal Revenue Code and State Laws. For example, attention must be given to Chapter 14, IRC Sections 2701, 704(b) and (e), 2704(a), 2703(b).
If you would like to speak with us about a similar issue, or another complex estate planning matter, don’t hesitate to call us today.