Providing timely, critically objective information to producers, professionals and agribusinesses concerning the application of important developments

providing timely, critically objective information to producers, professionals and agribusinesses concerning the application of important developmentsin agricultural law and taxation

2321 N. Loop Drive, Suite 200 Ames, IA 50010 (515) 294-5217

Business Succession/Estate Planning – Tax, Non-Tax and Entity Considerations*

Roger A. McEowen**

_______________

*Presented at the 2013 National Farm Business Management Conference, Overland Park, Kansas, June 10, 2013.

**Director of the ISU Center for Agricultural Law and Taxation. Member of the Iowa and Kansas Bar Associations and licensed to practice in Nebraska.

http://www.calt.iastate.edu/index.html


H.R. 8 - The Fiscal Cliff Bill

• What the Bill does not do:– No extension of the payroll tax cut

• 6.2% rather than 4.2% ($113,700 wage base)• Applies to wages paid and self-employment

income paid with return• Note:

– Don’t forget .9% Medicare surtax on earned income exceeding $250,000 (MFJ); ($200,000 single)

– Does not address carried interest



HR 8: the Fiscal Cliff Bill

Ordinary Income Rates

Old Law:

Top rate of 35%, starting at taxable income MFJ, $388,350

New Law:

Top rate of 39.6%, starting at $450,000 MFJ taxable income, $400,000 single.



HR 8: the Fiscal Cliff BillNew Brackets

SingleTo $8925 10%

-to $36,250 15%

-to $87,850 25%

-to $183,250 28%

-to $398,350 33%

-to $400,000 35%

>$400,000 39.6%

MFJTo $17,850 10%

-to $72,500 15%

-to $146,400 25%

-to $223,050 28%

-to $398,350 33%

-to $450,000 35%

>$450,000 39.6%



Marriage Penalty Returns (and is worse than before)

• Example – Married couple with each earning wages of

$400,000• Income tax owed - $260,000• Medicare surtax - $4,950

– Two single persons living together each earning wages of $400,000

• Income tax owed - $228,000 (total)• Medicare surtax - $3,600 (total)




New Brackets

39.6% bracket for trusts begins at $11,950 for 2013(replaces old 35% bracket)

Note: This is the IRS position, but it may not be correct – rate may only be 35%



Trust Tax Rates• Sec. 101(b)(1)(B) of ATRA adds I.R.C. Sec. 1(i)

(3), which says that rate of tax under subsections (a),(b), (c) and (d) rises from 35% to 39.6% for income above the “applicable threshold”– Trusts and estates are not taxed under any of these

subsections– ATRA provides no threshold amounts at which the

39.6% bracket would start– Thus, 39.6% bracket should not apply to trusts and

estates



HR 8: the Fiscal Cliff BillPhase-out of itemized deductions

(The “Stealth Tax”)

Itemized deductions phase out for each dollar of AGI over:

• $300,000 (MFJ) $275,000 (HOH)

• $250,000 (Single filers)

• $150,000 (MFS)

• So, what’s the impact of reinstating PEP and PEASE?

• PEP reduces personal exemption by 2% for every $2,500 of income above the threshold amount for single taxpayers and every $1,250 of income above threshold amount for MFJ

• Personal exemption is $3,800/person, so a married couple with 2 kids with incomes above $300,000 (up to about $425,000) will have about a 4% increase in marginal tax rate



Pease Limitation

• Pease cuts itemized deductions by 3% of AGI above the threshold amounts up to maximum of 80%

• Deductions not included:– Investment interest– Medical expenses– Casualty, theft and wagering losses



HR 8: the Fiscal Cliff BillPhase-out of itemized deductions

(The “Stealth Tax”)

The phase-outs cause tax increases to kick in at much lower levels.

-Families in 33% bracket could have an effective marginal rate exceeding 38%

-Families in 39.6% bracket would have an effective rate over 46% (after adding in Medicare surtax of 3.8%)



HR 8: the Fiscal Cliff BillNew Brackets, adjusted for phase outs

Single$183,250-$398,350 (33.99%)$398,350-$400,000 (36.05%)$400,000 and up (40.788%)

MFJ$223,050-$398,350 (33.99%)$398,350-$450,000 (36.05%) $450,000 and up (40.788%)



HR 8: the Fiscal Cliff BillNew Capital Gain Brackets

(as applied to taxable income)

Single

To $8925 0%

-to $36,250 0%

-to $400,000 15%

>$400,000 20%

MFJ

To $17,850 0%

-to $72,500 0%

-to $223,050 15%

-to $398,350 15%

-to $450,000 15%

>$450,000 20%

Adjust for the phase-outs as needed.



How Do The Higher Rates Apply To Clients With Both Ordinary Income and LTCGs?

• Example:– Bob and Mary file as MFJ and have ordinary

income of $300,000 and LTCG of $200,000. Thus, taxable income after deductions is $500,000

• Threshold for 39.6% rate is $450,000, so at what rate is the capital gain taxed? In other words, what is the ordering rule?

– Does the capital gain get applied to the threshold first, so that it’s taxed at 15%?

– Does the ordinary income get applied to the threshold first, so that none of the ordinary income is subject to the 39.6% rate, and a portion of the capital gain is taxed at 15% and the balance at 20%?



Capital Gain/Ordinary Income Ordering Rule

• Of course, the Congress didn’t answer the question in H.R. 8

• Look to I.R.C. §1(h)– Determine portion of taxable income that will be subject

to ordinary rates using graduated rate tables• Greater of taxable income reduced by capital gain ($300,000),

or• Lesser of

– Amount of income taxed at rates below 25% ($72,500 for MFJ in 2013), or

– Taxable income less adjusted capital gain ($300,000)



Continuing the Example

• The $300,000 of the $500,000 of taxable income is taxed at ordinary income rates, subject to the graduated rate tables– None taxed at 39.6% (even though taxpayer

has taxable income over $450,000) because their ordinary income does not exceed $450,000



Continuing the Example

• How much of the LTCG is subject to the 0% rate?– H.R. 8 extends the 0% rate for taxpayers otherwise in the

10% or 15% bracket.– The amount of the 0% rate is the lesser of:

• Net capital gain ($200,000), and • The top of the 15% bracket ($72,500) reduced by taxable

income less adjusted taxable gain ($500,000 - $200,000) [$72,500 - $300,000 = 0]

– Thus, none of the capital gain is taxed at the 0% rate.



Capital Gain Example

• Clay Tile– $600,000 of Schedule F net income for 2013. – Sale of farmland in 2013 that had

unharvested crop• LTCG of $800,000

– $60,000 of itemized deductions



Capital Gain Example

• Tax issues associated with unharvested crop– No deductions for expenses (add to basis)– Gain is LTCG if land held for more than a year– Allocate portion of selling price to unharvested crop– Result changes if retained right to reacquire land– What about pre-paid expenses?

• Amended return

– Potential application of 3.8 Medicare surtax



Return to Clinton Era Tax Rates?

• The Administration touts the deal as a “return to Clinton-era tax rates”– Not a chance:

• Capital gain rates about 3-5% points higher• Medicare tax is higher• Stealth tax makes individual rates higher than advertised

– Economic growth slowed down (as did revenues) after the Clinton tax hike

• Real wages declined



HR 8: the Fiscal Cliff BillAt least we have an AMT fix

-Single AMT exemption for 2012: $50,600

-MFJ AMT exemption for 2012: $78,750

-Adjusted henceforth for inflation

-Retroactive for tax years beginning after 2011, an individual can offset their entire regular tax liability and AMT liability by the nonrefundable personal credits

-Adjust for the phaseouts as needed



HR 8: the Fiscal Cliff BillAMT Capital gain rates

They are same as regular tax capital gain rates, but using AMT taxable income.




Permanency of Transfer Tax Provisions

• Rate raised to 40% (from 35%)• Lifetime exemption remains at $5 million, with inflation

indexing ($5,250,000 for 2013 deaths)• The exclusion remains coupled

• Matching Gifting and GST exemption• “Portability” retained (surviving spouse can inherit

decedent’s unused exemption)

2



Transfer Tax Changes

• The rate change is easy to deal with– No carryover effect from year-to-year or from

gifts to estates– No need to revise familiar estate planning

techniques– New law doesn’t give any reason to alter existing

plans• But revisit plans where there have been changes in

finances or personal life



Transfer Tax Changes

• How the new rate structure works:– 40% rate reached at a taxable estate or

cumulative gifts of $1 million• The “run up the brackets” for the first $1 million is

$54,200 (i.e., any tax payable would be $54,200 less than if the tax were a flat 40% from the first dollar)

– Unified credit is $2,045,800 and offsets a taxable estate (or taxable gift) of $5.25 million



State Estate Taxes

• State estate taxes remain deductible in calculating the federal taxable estate

• In those states (most of them) that don’t have an estate tax, or have a state estate tax that is coupled to the (now extinct) state death tax credit, 40% will be the only estate tax rate above the exemption



State Estate Taxes

• Most states that have an estate tax tie it to the pre-2002 federal credit for state death taxes– Top rate of 16% for taxable estates over $10.1

million

• In states that follow the federal law and allow a deduction for the state tax, the total federal and state top marginal rates will be 48.3%



Portability• Made permanent• Technical correction made

– “Basic exclusion amount” changed to “applicable exclusion amount” in I.R.C. §2010(c)(4)(B)(i)

• June 15, 2012 portability regulations remain applicable

• Still have to file Form 706 in first spouse’s estate to make election– 9 months after death with 6 month extension

possible



Impact of Portability

• Since it is now “permanent,” the use of bypass trusts for all but the wealthiest of families might be reduced

• But, there are still reasons to use bypass trusts:– Protect assets from creditors– Surviving spouse might remarry– Assets might go down in value– Plan might already use a bypass trust– Bypass trusts avoid administrative pitfalls



Estate Planners Not Irrelevant

• Many non-tax reasons to see an estate planner:– Asset protection through entities, trusts, pre-nups

and post-nups– Planning for long-term health care– Powers of attorney– Reviewing beneficiary designations and

coordinating them with estate plan– Business succession



GSTT

• Made permanent is the allocation of the GSTT exemption and the GSTT inclusion ratio

• Exemption same as that for estates and gifts ($5.25 million for 2013)



Transfer Tax Issues

• What was not included in the bill:– No attack on valuation discounts– No 10-year term limit on GRATs– No limit on the duration of the allocation of the

GSTT exemption



HR 8: the Fiscal Cliff BillRetroactive business extenders

• 5-year S corporation built-in gain recognition period• For 2012 and 2013 (10 year rule in 2014)

• Thus, S corporations with BIG that have been an S for at least 5 years as of the beginning of 2012 or 2013 will not owe BIG tax on sale of appreciated assets

• If installment sale made after recognition period (e.g. 5 years) and recognition period reverts to 10 years, gain on installment sale is protected from BIG tax

• If BIG income is carried forward to future years due to taxable income limitations and BIG period has expired, no BIG tax on expired amount

3



HR 8: the Fiscal Cliff BillEnergy-Related Provisions

• “Renewable” Energy PTC• Extended for one year

• Taxpayer can make irrevocable election to take a 30% energy credit instead of the PTC

• Qualified property defined as being constructed, reconstructed, erected or acquired by the taxpayer and the original use of which commences with the taxpayer



HR 8: the Fiscal Cliff BillSection 179 limit raised for 2013 – and 2012

• Limit for 2012 had been $139,000, with deduction starting to phase out at $560,000.

• 2013 limit had been $25,000, with phase-out starting at $200,000

2



HR 8: the Fiscal Cliff BillSection 179 limit raised for 2013 – and 2012

• New law boosts limit for both 2012 and 2013 to $500,000, with phaseout starting at $2 million.• Windfall for clients that purchased expensive assets

in 2012 and thought they would be limited to $139,000

• Limit to return to $25,000 in 2014.• The $139,000 amount for 2012 is gone

2




Section 179 provisions from 2011 extended• Includes treatment of up to $250,000 in “qualified real

property” expenses and qualification of computer software for Section 179 treatment.

• You can still make or revoke a Section 179 election on an amended return for open tax year • Good through tax years beginning before 2014• Huge planning opportunity



Bonus Depreciation

• 50% first-year bonus depreciation extended for 2013

3



Expense Method and Bonus Depreciation

• Sec. 179– New or used equipment– No farm buildings, unless they are single-

purpose agricultural/horticultural structures– Use in trade or business – Must have income from trade or business



Expense Method and Bonus Depreciation

• Bonus Depreciation– 20-year MACRS property or less– Must be new– Farm buildings

• Ordering rule– Sec. 179 first, then bonus, then regular

MACRS



Charitable Donation To Charity From IRA

• Reinstated for 2012 and extended through 2013• Must be over age 70.5• Limit is $100,000 annually• Donation must be to qualified charity directly (trustee of IRA must draft

check in charity’s name)• Any distribution received during 12/12 not included in income if donated

during 1/13• Distribution cannot be taken into account for determining the “other”

charitable contributions to be allowed as a deduction under I.R.C. Sec. 170– In other words, the distribution cannot be added to AGI for purposes of the AGI

limitation

• Can help avoid 3.8% Medicare surtax (if desire is to benefit charity)– Required distribution is passive and counts toward threshold, but not if donated

directly to charity



ACA (Obamacare) Provisions Starting in 2013

• Medical expenses (Schedule A)– Reduced by 10% of AGI for those under age

65• Applicable if either spouse under age 65

– If 65 or older, reduced by 7.5%• Applicable if either spouse 65 or older

7



New Excise Tax on Medical Reimbursement Plans

• I.R.C. Sec. 4376. – An amendment to ERISA added by ACA. – Imposes a "fee" on any applicable self-insured health plan for

each plan year ending after 9/30/2012. • Fee is $1 per average number of lives covered under the plan for

plans that end during fiscal year 2013, $2 thereafter. • The fee is to be paid by the "plan sponsor" defined as the employer

for plans established or maintained by a single employer. • An "applicable self-insured plan" is any plan for providing accident or

health coverage if any portion of the coverage is provided other than through an insurance policy and is established or maintained by 1 or more employers for the benefit of their employees.

• An excise tax remitted via Form 720. • First payment is due Jul. 31 for the calendar year 2012. Basically, it's

due seven months after the plan year end. It doesn't apply to plan years ending after 9/30/2019.



Proposed regulations on 3.8% tax on “Net Investment Income”



The ACA imposes two related taxes:

• A 0.9% wage tax high-income individuals, paired with a 0.9% self-employment tax at the same income levels. (Sec. 3101(b)(2))– No employer match on the 0.9% tax

• A 3.8% tax on "investment income" at higher AGI levels. (Sec. 1411)

6-7



Wage/SE tax applies to:

• Wage/SE income over $200,000 for single filers

• Joint wage/SE income over $250,000 for joint filers, or

• Wage/SE income over $125,000 for married taxpayers filing separately.



Wage/SE tax

• Employers will have to withhold when wages for an individual exceed $200,000. Any shortfall or overpayment has to be dealt with on the employee 1040.

– Example: Jack and Jill each earn $150,000 in 2013

wage income. Because both are below $200,000, no 0.9% tax will be withheld on their wages. When they file their 2013 return, they will owe $450 (($300,000-250,000) x .9%) as additional tax on their 1040.



Implications for partners? Choose your poison!

• If you materially participate in a partnership with trade or business income, you will have self-employment income, potentially subject to the .9% tax – and the old 2.9% Medicare tax.

• If not, you will have passive income subject to the 3.8% tax.



Implication for S corporations: more reason to keep a lid on "compensation."

• S corporation K-1 income is not subject to FICA or SE tax.

• Reasonable compensation required.



Implication for Entity Planning

• S corporation is favored over partnerships because of better ability to avoid both employment tax and investment income tax of active owners.



Investment income (Sec. 1411)

• 3.8% tax applies to lesser of “net investment income" or the excess (if any) of the taxpayer’s "modified AGI" over:– $200,000 for single filers– $250,000 for joint filers, and – $125,000 for married taxpayers filing

separately.– Top bracket cutoff for trusts ($11,950 in 2013)



NII

• The 3.8% surtax is not deductible• Self-employed persons can’t claim the

surtax as part of the 50% deductible portion of S.E. taxes under I.R.C. §164(f).



Investment income includes:• Interest not derived in the ordinary course of a trade or

business. (Preamble Sec. 5.A) – This excludes interest earned in a banking business. See

Preamble Sec. 5.A.vi.• Dividends• Rents• Non-qualified annuities to extent taxable and required

minimum distributions• Royalties• Capital gains, except from sales of active businesses

• But, include capital gain from sale or liquidation of closely-held C corporation, even though taxpayer materially participated

• Passive trade or business income



“Net Investment Income” Does Not Include

• Salary, wages or bonuses• Distributions from IRAs or qualified plans• Pension income• Any income taken into account for self-employment

tax purposes• Gain on the sale of an active interest in a partnership

or S corporation• Items which are otherwise excluded or exempt from

income under the income tax law



Capital gain from the sale of interests in partnerships and S corporations (1.1411-7)

1. The partnership or S corporation is deemed to dispose of all of the entity's properties in a fully taxable transaction for cash equal to the fair market value of the entity's properties immediately before the disposition of the partnership or S corporation interest.

2. Determine the amount of gain or loss for each property.



Capital gain from the sale of interests in partnerships and S corporations (1.1411-7)

3. “Applying the rules of chapter 1, the partnership or S corporation determines the amount of gain or loss for each property that is allocable to the interest disposed of by the transferor.”

4. Adjust out the gain attributable to non-passive property items from the total gain.



Sec. 1411 tax

• Running investment income through a pass-through that otherwise has trade or business income does not avoid the tax.



Net Investment Income: Itemized Deductions

• Taken into account to extent allowed as a deduction. Examples include:– Investment interest– Investment expenses (e.g., >2% AGI)– Income taxes “properly allocable” to gross income.

Allocation based on gross income is proper (1.1411-4(f)(3)(C)

• Pass-through entity disclosure isn’t addressed. Query state taxes on pass-through income (e.g. Illinois, California, Kentucky) and composite state taxes.



3.8% Surtax – Application to Trusts and Estates

• 3.8% of lesser of undistributed NII for the tax year, or the excess (if any) of AGI for tax year, over the dollar amount at which highest tax bracket begins ($11,950 for 2013).– Note: If beneficiaries do not have sufficiently high MAGI

and passive income such that they would not be subject to the 3.8% surtax, and are not otherwise in the highest marginal tax bracket, fiduciary should distribute the amount of AGI for trust or estate that exceeds the threshold for the top rate



Trusts and Passive Income

• The IRS view is that only the trustee, acting in its capacity as trustee, can satisfy the material participation test for a trust– No regulations– The one court that has decided the issue said the

IRS position is “arbitrary, subverts common sense, and attempts to create ambiguity where there is none”

– Tax Court case pending.



3.8% Surtax

• Critical terms:– Net investment income– Threshold amount

• $200,000 (single)• $250,000 (MFJ)• $11,950 (trusts and estates)

– Modified adjusted gross income• AGI (line 37 of 1040) plus net foreign earned income

exclusion



Illustration of investment income:MAGI Investment Income

Wages 300,000

Interest 10,000 10,000

Non-qualified Annuity 20,000 20,000

403(b) annuity 30,000

Gain on stock sale 40,000 40,000

Gain on principal residence

800,000 800,000

Residence gain exclusion (500,000) (500,000)

Total 700,000 370,000



Illustration of function of income threshold:MAGI Investment Income

Wages 150,000

Dividends 5,000 5,000

Interest 15,000 15,000

403(b) annuity 30,000

Gain on stock sale 40,000 40,000

Passive Income 15,000 15,000

Non-passive income 5,000

Total 260,000 75,000

Tax Base 10,000 75,000

Tax 380



Another Example

• Single taxpayer– $100,000 of salary– $50,000 of net investment income– MAGI is $150,000– MAGI is less than threshold – no 3.8% tax



Another Example

• Single taxpayer– $0 employment income– $225,000 net investment income– MAGI is $225,000– MAGI exceeds threshold by $25,000– Surtax is .038 x $25,000 = $950



Another Example

• Married filing jointly– $300,000 combined salary– $0 net investment income– No surtax (wages exempt)



Another Example

• MFJ– $400,000 salary income– $50,000 net investment income– Surtax applicable to $50,000 of net

investment income• .038 x $50,000 = $1,900



Another Example

• MFJ– $200,000 salary income– $150,000 net investment income– Excess of MAGI over threshold is $100,000– Surtax is .038 x $100,000 = $3,800



Another Example

• Single– $200,000 investment income– $125,000 RMD from IRA– MAGI is $325,000– Excess of MAGI over threshold is $125,000– Surtax is .038 x. $125,000 = $4,750



Another Example

• MFJ– $100,000 pension income– $150,000 IRA income– $25,000 tax-exempt interest– There is no net investment income, so no

surtax



Passive income tests

• 500 hours in an activity

• Significant participation - 100-to-500 hour activities that add to 500 hours in a year

• Substantially-all participation in the activity

• 100 hours, and as much as anyone else

• Materially-participated in 5 of last 10 years (or any three years for personal service businesses)



Special Rule For “Retired" Farmers

• Material participation in 5 years in the eight year period before you start drawing social security is evergreen.



Special rule for real estate professionals to avoid "per-se passive" treatment: threshold test

• 750 hours of participation in real estate trades or businesses owned, and

• More real estate hours than anything else.



Recharacterization

• Tax rules treat some otherwise passive income as non-passive, including– Land rent (under 30% of unadjusted basis

depreciable)– “Self-rental” to a material participation activity



Grouping: real estate and other items. What is an "activity?"

• Sec. 469(c)(7) grouping election for real estate pros

• Other taxpayers can group appropriate units, but must disclose groupings and cannot change absent material change in circumstances.



Grouping basics (1.469-4(d))

• Rental and trade or business activities may not be grouped unless one is “insubstantial” with respect to the other.

• Real property rental activity cannot normally be grouped with personal property rental.

• You can group activities of renting from one activity to another if both activities have identical ownership.



Disclosure of groupings (Rev. Proc. 2010-13)

• Grouping changes must be disclosed on returns.

• Once made, groupings can’t be changed by taxpayer unless initial grouping was “clearly inappropriate” or there was a “material change in circumstances”.

• New activity groupings must be disclosed.



Special grouping election in proposed regulations (Proposed Reg. Sec. 1.469-11(b)(3)(iv)).

• May regroup activities in first taxable year beginning after December 31, 2013 that they are over the income threshold and have net investment income.

• Taxpayers over the threshold may regroup for 2013.

• Taxpayers may only regroup once under this provision.

• Regrouping must be disclosed pursuant to 1.469-4(e) and other regrouping rules.



Required disclosure (1.1411-7(d))

1. A description of the disposed-of interest;

2. The name and taxpayer identification number of the entity disposed of;

3. The fair market value of each property of the entity;

4. The entity's adjusted basis in each property;



Required disclosure (1.1411-7(d))

5. The transferor's allocable share of gain or loss with respect to each property of the entity

6. Information on whether property was subject to the tax

7. The net amount of gain, and

8. The computation of the gain subject to the Sec. 1411 tax.



Self-rental

• Are "self-rentals" that are non-passive subject to the 3.8% tax as rentals?

– “Self-rental” income that is not passive under the passive loss “recharacterization” rules will still be subject to the Sec. 1411 tax. Preamble Sec. 6.B(i)(b)(3)



Real estate professionals• Real estate professionals get lame guidance:

– If a taxpayer meets the requirements to be a real estate professional in section 469(c)(7)(B), the taxpayer's interests in rental real estate are no longer subject to section 469(c)(2), and the rental real estate activities of the taxpayer will not be passive activities if the taxpayer materially participates in each of those activities. However, a taxpayer who qualifies as a real estate professional is not necessarily engaged in a trade or business (within the meaning of section 162) with respect to the rental real estate activities.



Planning issues

• Affects gifting, grouping decisions.

• Compensation issues. If you are going to claim material participation in an S corporation or LLC, you should expect to pay wages or SE tax.

• Monitoring participation: if participation is even potentially iffy, the taxpayer should keep a current time diary.



Implications for Trusts

• Trusts threshold is the top tax rate bracket under the proposed regulations (1411(a)(2)).– Surtax applies to lesser of undistributed NII or the excess of an

estate/trust’s AGI over $11,650

• Regulations allocate investment income between distributed and undistributed income under usual trust allocation rules.

• Electing small business trusts will have to combine their S corporation and non-S corporation portions for computing the tax (Proposed § 1.1411-3(c)(1)(ii)).



3.8% Surtax – Planning Strategies

• Anything that reduces NII or MAGI will reduce or eliminate the 3.8% surtax

• Increase municipal bond investments• Maximize qualified plan contributions• Avoid spikes in income• Structure farm business as a member-managed

LLC– While non-manager’s interest is passive, spouse can

take into account m.p. of manager-spouse




SUCCESSION PLANNING

Volume B, Chapter 5



Reasons Why Businesses Don’t Have Succession Plans

• Successor doesn’t believe that the predecessor will ever retire– Arthur Andersen survey

• Between 25% and 33% of leaders of family businesses don’t intend to retire or plan to remain involved throughout their lives

• 30-40% of family businesses have no plan in place

• Taboo subject– Relationships and emotions involved– Business may be founder’s self-identification– Animosity toward younger generation

• Primogeniture




OBJECTIVES OF SUCCESSION PLANNING

•Objectives must drive the process and must be clearly articulated



Objectives of Succession Planning

• Successfully bringing the next generation into the business

• Providing vocation for next generation• Establishing a base for a financially

successful business into future• Providing a plan for the older generation• Providing an estate plan that is fair to

business and non-business heirs• Tax minimization

B197


Thread Through Other Efforts

Estate Planning

Business PlanningSuccession Planning

Steps to Successful Succession Planning

• Determine business owner’s long-term goals and objectives

• Determine financial needs of business owner and spouse and develop plan assuring financial security

• Determine who will manage the business and develop the management plan

• Determine who will own the business and how to transfer owner’s interest

• Minimize transfer taxes and establish estate plan



BUSINESS ORGANIZATION STRATEGIES

B198



Single Entity

Most U.S. Businesses

70 to 75% of farms and 50-60 percent of non-farm

businesses


Multiple Entities

OPERATIONAL ENTITY

REAL ESTATE ENTITIES

Sole ProprietorshipPartnership

LLCC CorporationS Corporation

__lease____

Parents’capital

Child’scapital

Equipment

LLC

B198


Operational Entity

• Typical choices include:– Sole proprietorship– General partnership– LLC– C Corp– S Corp



Operational Entity

• Assets Possible to Be Placed into Business– Checkbook– Inventory– Equipment– Very Limited Real Estate



Landholding Entities

• Selected entity is usually sole proprietorship or LLC

• Typically not wise to put real estate in corporation



Basic Entity Choices(See Pages B199-200 for Summary Table)

• Sole Proprietorship• General Partnership• Limited Partnership• Limited Liability Company• Limited Liability Partnership• S Corporation• C Corporation• Cooperatives



Primary Considerations in Choosing Entity Form

• Continuity– Corporation– Sole proprietorship– General partnership

• Giles v. Giles Land Co. (Kan. Ct. App. 2012)



Removing a Partner Without Terminating the Partnership

• Giles v. Giles Land Co. (Kan. Ct. App. Jun. 15, 2012)– State partnership dissociation statute invoked to

remove the “magnanimous savior of the family”• Must value and buy-out his interest

• Note: In a limited partnership, a limited partner can assign their interest without impacting dissolution

B201



Transferability of Entity Interests

• Transferring entity interests rather than individual assets– Partnership interests– LLC interests

• Is transferred property subject to debt?• What about bankruptcy exemptions?

B201-202



Flexibility

• Corporation – perhaps greatest in terms of management structure

• Partnership – look to the agreement• LLC – the agreement controls

– Based on state law, chance for greater creditor protection

– Passive loss issue



LLCs and the Passive Loss Rules

• How is a loss characterized?– Depends on whether the taxpayer is materially

participating• Seven tests for material participation• Per-se rule of non-material participation for limited

partner interests in a limited partnership unless the Treasury specifies differently in Regulations

– Statute pre-dates states LLC statutes and advent of LLPs

• Three tests for limited partners in a limited partnership



LLCs and the Passive Loss Rules

• I.R.C. §469(h)(2)– Per-se rule of non-material participation for

limited partner interests in a limited partnership, unless regulations specify differently

• “Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates.”



Garnett v. Comr., 132 T.C. No. 19 (2009)

• Taxpayer incurred losses in LLCs and IRS characterized them as passive under the “per-se” rule

• Tax Court rejected IRS position– LLC is materially different than a partnership– Oregon Federal District Court had already

ruled similarly based on Oregon law



Thompson v. Comr., 87 Fed. Cl. 728 (2009)

• IRS position again rejected– IRS position given no deference



Hegarty v. Comr., T.C. Sum. Op. No. 2009-153

• Follows Thompson and Garnett



Newell v. Comr., T.C. Memo. 2010-23

• Is the managing member’s interest in a California LLC that was classified as a partnership for income tax purposes a limited partnership interest for purposes of Sec. 469?– IRS said it was– Court (again) said it was not– No unforeseeable circumstance present



Rental Activities and the Passive Loss Rules

• Remember, Sec. 469 disallows passive activity losses for any taxable year except to the extent they offset passive income– Rental activities are per se passive (with two

exceptions)• Real estate professionals (Sec. 469(c)(7))• $25,000 annual deduction if AGI $150,000 or less

(Sec. 469(i))



Rental Pros

• Losses fully deductible if material participation present

• But, what is a real estate pro?– More than 50% of personal services performed in

trades or businesses by taxpayer during year must be performed in real property trades or businesses in which taxpayer materially participates

– 750-hours in real property trades or businesses in which taxpayer materially participates



Chambers v. Comr., T.C. Sum. Op. 2012-91

• Real estate professional test invoked– 750 hours– More than 50% test

• IRS said petitioner’s hours spent in LLC management activities didn’t count– Court disagreed based on Garnett



Limited and General Partnerships

• Prop. Treas. Reg. (Nov. 25, 2011)– For purposes of passive loss rules, focus is

on whether taxpayer has right to participate in management at any time during tax year



Organizational Options

• Self-Employment Tax– If an LLC is not conducting a business, there

is no self-employment income.– If an LLC is conducting a trade or business,

then self-employment income results, unless the limited partnership exception exists (Sec. 1402(a)(13)).



Liability

• Sole proprietorships and general partnerships– Unlimited liability

• LLCs and corporations– Limited liability– Tax issues typically drive the decision– Charging orders (B203)

• Example 2

B202



Liquidation Costs

• C Corp– Highest liquidation cost– Distributions in excess of stock basis result in

capital gain

• S Corp– Others

• LLC– Distribution of assets on tax-free basis

• Discounting of Business Interests

B204



Organizational Considerations• Income tax considerations

– Double level tax for corporations other than S corporations

– Recognition of gain on liquidation for S corporation liquidating distributions §311(b)

– Flow-through tax considerations with no or limited gain recognition on liquidation for partnership-type entities

• LLCs• LPs• GPs, etc.

B206



What To Consider Before Making S Election

• Unused NOLs of C corporation cannot be used by S corporation to offset future S corporation income

• S corporation compensation issues– Payment of “reasonable” wages

• Payroll tax issue– Watson case– No cases involving issue of reasonable compensation

where salary at least at FICA wage base



Using an S Corp. To Minimize FICA & Medicare Tax

• Watson, 668 F.3d 1008 (8th Cir. 2012) – Taxpayer earned 200,000 in 2002 and 2003

from CPA business but paid himself annual salary of 24,000 (firm established as a partnership of S corporations)

• Court reclassified about $67,000 of S corp. dividends as salary for each year resulting in about $91,000 of FICA/Medicare wages

B206



S Corporation Tax Fails (Again)

• S. 2343– Would have applied payroll tax to taxpayers

with income over $250,000 by requiring them to include for payroll tax purposes income received from an S corporation or L.P. interest in professional services business where 75 % or more of gross revenue derived from services of three or fewer shareholders



S Corporation Disproportionate Distributions

• Can make disproportionate distributions to correct disproportionate distributions– PLR 201236003 (Apr. 11, 2012)

B207



S Corp. Debt Basis Regs.

• How to increase basis:– Bona fide debt– Circular loans can work– Guarantees don’t work unless shareholder

actually makes payment– Unsecured promissory note doesn’t work



Fringe Benefits

• Health Insurance and retirement plans– Tax distinctions between various entities

• Qualified retirement plan options

B207



Valuation Discounting• FLPs

– No recognition of gain or loss for FIT purposes to either the party making the transfer or to the entity. Sec. 721(a)

– Change in theoretical basis for fractional interest.• Interests in farmland if held by more than one person

may qualify for fractional interest discounts.– Take the FMV of the land as a whole and subtract the estimated

costs of a partition action divided by the percentage of land held– Once land is held by an entity, the valuation of units will be

subject to normal lack of marketability, minority interest discounts and (perhaps) a control premium

B210



Valuation Discounting

• FLPs– Change in status of property for state law

purposes• Real estate of real property is normally sitused for

purposes of state death tax statutes to the place where the land is located

– Result not normally changed even if the land is held by a revocable trust

– NOTE: LLC interests are generally personal property and personal property is generally sitused to the decedent’s state of residence



Family Limited Partnerships

• Keller, et al. v. United States, No. 10-41311, 2012 U.S. App. LEXIS 20119 (5th Cir. Sept. 25, 2012)– In 1998, $300 million transferred into revocable trust. FLP

later created but not community property bonds that were to fund it not transferred before wife died on 5/15/00.

• Estate paid over $147 million in estate tax in 2/01• FLP funded post-death• FLP funding meant that estate didn’t have funds to pay estate

tax; transaction restructured as $114 million loan and estate issued promissory note at Feb. ‘01 AFR

• Estate filed claim for refund in 11/01



Keller v. United States(5th Cir. Sept. 25, 2012)

• Grounds for refund claim:– Failed to claim discount– Failed to claim deduction for interest paid on

loan

• Estate wins– Under TX law, the intent to transfer the bonds

to the FLP was sufficient – refund of $115 million



Current Developments in Estate and Business Planning

• Family limited partnerships (FLPs)– Estate of Wimmer

• Making sure gifts of FLP interests qualify as present interests even where restrictions present

– Right to income from the interests– FLP generated income from its investments– Some portion of the income would flow to donees on

consistent basis– Amount flowing to donees could be ascertained



You Can’t Take a 40% Discount on a 100% Interest

• Estate of Lockett– Mrs. Lockett moved into an assisted living facility

when her health began to decline and formed an FLP and funded it two years later with cash and marketable securities from her trust and her personal assets. Trust later dissolved, and Mrs. Lockett became sole owner of the partnership. Two sons listed as general partners in the agreement, but the sons never contributed any assets, and their interests were listed as 0 in the agreement.



Estate of Lockett

• After the funding of the partnership, the partnership made loans to some of the children – many of which were documented in loan agreements with no terms on the principal payment, but with interest payments set up. The partnership also purchased some rental property and Mrs. Lockett kept some assets out of the partnership to care for herself.



Estate of Lockett

• Estate filed a tax return and claimed 40% discount on the partnership assets

• Two issues at trial,– Whether Mrs. Lockett held the assets

individually or in the partnership; and – Whether the loans were gifts or loans.



Estate of Lockett• Court found no evidence of property contributed

by the two sons or gifts of partnership interest to the two sons.

• After the dissolution of the trust, Mrs. Lockett directly owned 100% of the partnership– FLP agreement supplemented that observation

because it provided that if a partner acquired all the interests of the other partners, the partnership would dissolve.

– Court ultimately found that the assets belonged to the estate, so no discounts were justified.



Estate of Turner

• Transferred FLP assets were included in the decedent’s gross estate.

• Court also addressed the issue of whether the decedent’s payment of life insurance policy premiums were subject to the annual exclusion under Section 2503(b).



Estate of Turner

• Sloppy Crummey gifting– Decedent was grantor of irrevocable life insurance trust that had

purchased three separate life insurance policies. – In 2000-2003, the decedent paid the insurance premiums

directly from a joint checking account instead of transferring money to the trustees to pay the premiums.

• IRS included the premiums paid on the life insurance policies in the estate’s total adjusted taxable gifts.

• Tax Court held that the premium payments were a gift of a present interest and were subject to the annual exclusion under Section 2503(b) – beneficiaries had “right to demand withdrawals from the trust”



Other FLP Issues

• Estate of Stone and Estate of Kelly – Survive attack– Bona fides

• Creation of family asset to be managed by family• Transferors not dependent on distributions from FLP• No commingling of personal and partnership funds• No discounting of interests claimed• Transferors in good health at time of transfer• No evidence of implied agreement




HEIRS NOT IN THE BUSINESS

How to achieve equitable treatment

B213



Heirs not in the Business

• Usually not wise to involve non-business heirs in day-to-day operations– Often do not distribute any income– Operational business may have day to day

decisions that do not match objectives of business heirs

– Ownership usually small compared to on business heirs

– Little incentive for business heirs to buy out interest of non-business heir

• Value of non-business heir’s minority interest has severe value discount



How to Treat Non-Business Heirs

• Inheritance or gift• Beneficiaries or life insurance• Beneficiaries of retirement plans• Acquire interest in business real estate

– Possibly in conjunction with gifting




• The non-business heir may not be distributed an equal share in the value of assets

• If non-business heir were to receive real estate– Subject to long term rental contract in favor of

business heir’s business– Subject to purchase options favoring business heir– Placed into an entity in which either all heirs are

co-owners




• Seldom is it recommended that real estate be inherited by children as tenants in common– Joint decision making difficult– Each co-owner has power of partition– Usually no structured buy-out provision– Often questions of rights of possession



Other Ways to Minimize Estate Tax?

• “Charitable Lid” Planning– An estate plan is created where the testator

leaves a set dollar amount of the estate to the children with the residuary estate passing to a charitable organization.

• The portion passing to the charity qualifies for the estate tax charitable deduction and, thus, puts a lid on the amount of estate tax owed

B214



“Charitable Lid” Planning

• Attractive technique when combined with hard to value assets such as business interests or family partnership interests

• Good way to defeat an IRS audit– If IRS challenges the valuation of assets on

audit, any increase in value on audit does not increase the estate tax due – it simply passes to the charity

B214



“Charitable Lid” Planning

• Key case – Christiansen v. Comr., 130 T.C. No. 1 (2008)– Decedent owned cattle ranches in South Dakota with

her husband. He died in 1986 and she continued to operate the ranches until her death in 2001. Her entire estate passed to her daughter, but the will said she could disclaim all or any portion of her inheritance, with the disclaimed property passing 75 percent to a CLAT and 25 percent to a private foundation



Christiansen Case• Daughter filed a disclaimer. Largest asset in

estate were FLP interests that carried out valuation discounts.– With discounts, decedent’s estate was just over

$6.5 million– Daughter’s disclaimer resulted in the foundation

and the CLAT receiving about $140,000– IRS audited and increased FLP interests by about

35% - but that resulted in more property passing to charity and no increase in estate tax

• Daughter did not retain a continuing interest in the CLAT after the disclaimer, so no charitable deduction



Christiansen Case• IRS appealed the portion of the decision

allowing the enhanced deduction for the amount passing to the foundation– Attacks the disclaimer:

• Any amount passing to the charity was contingent on a condition subsequent (i.e., the Service’s ultimate determination of value of the decedent’s estate)

• Adjustment clause in disclaimer should be declared void on public policy grounds – discourage them from examining estate tax returns

– Court disagreed with IRS (586 F.3d 1061)



Petter v. Comr., T.C. Memo. 2009-290• Court upheld a defined-value gift tax clause

and rejected IRS’ policy-based argument– UPS stock in LLC transferred to IDGTs and

charities, with split determined by formula– IRS tried to negate defined-value clause based

on policy reasons, but court determined that gift was of ascertainable value of stock rather than a specific number of shares or percentage interests in LLC

• 9th Circuit affirmed on appeal (Aug. 4, 2011)



Hendrix v. Comr., T.C. Memo. 2011-133

• Court approved transfers with “defined value” formula provisions to limit gift tax exposure from the transfers– Transfer of closely held stock in a gift/sale

transaction to family trusts and gift to Foundation under coordinated formula provisions was at arm’s length and not contrary to public policy

– Clause at issue allocated stock between family trusts and Foundation based on values as determined by IRS willing buyer/willing seller test



Wandry v. Comr., T.C. Memo. 2012-88

• Facts: – Married couple gifted membership units in LLC to children and

grandchildren; transfers made in accordance with dollar value of gifts and were determined by a fraction (numerator was state dollar amount and denominator was value of entire company as determined by IRS or court)

– IRS claimed gifts were of fixed fractional interests in LLC and, as a result, LLC unit value understated; court determined that defined value clause reallocated LLC membership units among parties in conformance with formula in which unit value as of transfer date was "unknown constant“

– IRS lost– Appealable to 10th Cir. [Appeal docketed on Aug. 28]– Case settled in late October– IRS issued non-acquiescence on Nov. 9, 2012



Life Estate/Remainder Arrangements

• Handling Allocated Basis– Example:

• At death, Sam leaves $500,000 of securities to his wife, Sara for life, with the remainder passing to his son, Sid. Sara is 48 at the time Sam dies. Under 20.2031-7A(c), the life estate factor for a female age 48 is .77488 and the remainder is .22512. Thus, the present value of the portion of the uniform basis assigned to Sara’s life interest is $387,440, with $112,560 assigned to Sid. Sara sells her life interest to her nephew, Seth, for $370,000 while she is still 48. Sara does not realize a loss (Sec. 1001(e)) and her gain is $370,000. Seth’s basis is $370,000 which is recoverable by amortization over Sara’s life expectancy

B225




• Handling allocated basis– Example:

• Same facts, except that Sara retains the life interest until age 60 and then sells it to Seth when the securities are worth $650,000. The life estate factor for Sara is .63226 and the remainder factor is .36774. So, the present value at the time of the sale assigned to Sara’s interest is $316,130 and the present value assigned to Sid’s interest is $183,870. Sara sells her interest for $410,969 ($650,000 x .63226). Her gain is the amount realized, and Seth’s basis is $410,969.




• Handling allocated basis– Example:

• Larry died at age 39 owning a pasture worth $18,800 at the time of death. The land is devised to Lance for life, remainder to Lisa (unrelated). Shortly after Larry’s death, Lance sells his life estate, Lance and Lisa jointly sell the entire property to Loraine for $25,000 and divide the proceeds equally. The remainder factor for a 39 year old male is .20146, thus the present value of the uniform basis assigned to Lisa’s remainder interest is $3,787.45. On sale, Lance realizes a loss of $2,512.55 ($15,212.55 - $12,500) [this is the portion of uniform basis not disregarded] and Lisa’s gain is $8,712.55 ($12,500 - $3,787.45). Loraine’s basis in the entire property is $25,000 (none recoverable by amortization deductions over Lance’s lifetime.



Dynasty Trusts

• The GSTT– Tremendous planning opportunity through

balance of 2012 to fund GSTT trusts – Watch for Administration’s continued attempts

to limit planning opportunities• Limitation on GRATs• Elimination of valuation discounts via FLPs

B226



The GSTT

• Clearly of interest to wealthy clients• Don’t overlook GSTT trusts for clients with

more modest wealth• May not be of interest for small estates



Dynasty Trusts

• Avoidance of transfer taxes for multiple generations

• Lasts as long as allowed by maximum term allowed by local law



Dynasty Trusts

• Mechanics– Irrevocable trust– Spendthrift provision– Initial funding tied to grantor’s transfer tax

exemption• Take note of the net investment return possible

with enhanced exemption through 2012



Dynasty Trusts

• Tax aspects– Not subject to GSTT if grantor allocates

sufficient GSTT exemption to make inclusion ratio zero

• Must elect to allocate exemption to transfers• Need to preserve GSTT inclusion ratio for any

additional property transferred to the trust

B227



Dynasty Trusts

• Tax aspects– Treated as an irrevocable trust

• Initial funding subject to gift tax and will use up grantor’s unified credit to extent of excess over present interest annual exclusion



Dynasty Trusts

• Can be structured as grantor trust– Income accumulated tax-free– During settlor’s lifetime, settlor taxed on trust

income and gains– How to achieve grantor trust status:

• Trust terms give discretion over distributions of income and principal that can be exercised by majority of trustees that are related or subordinate to settlor

B229



Trust Term

• Tied to state’s rule against perpetuities– Establish situs in state with relaxed or no rule

• Trust term should so state• Appoint trustee located in jurisdiction with

favorable rule– Works for personal property– Real property governed by law of state where located



Dynasty Trusts

• Trustee considerations– Important to select carefully

• Consider limitations on trustee’s exercise of power• What is the process for replacing a trustee

B230-231



Dynasty Trusts

• Trustee as a fiduciary?– Most courts require that trustee must commit

serious breach before removal will be allowed– Statutory procedures may apply– UTC provision does not focus on trustee

conduct– Trustee retained powers and tax issues



Structure of the Trust

• Commonly drafted as spendthrift trust so as to provide asset protection– Beneficiary cannot assign or transfer or

encumber an interest in net income or principal of trust

• No creditor attachment until distribution

– Trustee has absolute discretion over distributions

B230



The Use of Life Insurance as a Succession Planning Tool

• General Comments– Tax favored status– What if estate tax (and stepped-up basis) is

repealed– If in ILIT, death benefits not subject to FET or

GSTT

B232



Life Insurance• Benefits of life insurance in business

succession process– Estate liquidity and asset preservation

• Ownership in ILIT• Proceeds payable to business owner’s estate via

loans or buying assets from estate at FMV• ILIT could buy decedent’ s business interest at

discount– Freeze accomplished– Cash received by surviving spouse could be gifted to

non-business heirs and/or fund ILIT for benefit of non-business heirs



Benefits of Life Insurance

• Wealth replacement• Estate equalization• Fund a buy-sell• Tax hedge• Retirement income• Fund stock redemption• Liquidity• NQDC



Benefits of Life Insurance

• Key-person insurance• GRATs• Asset protection planning• Private annuities and SCINS• Family bank



GRATs and GRUTs

• Types of irrevocable trusts• Established for a fixed term of years and the

donor/grantor retains an income right– Stated amount paid to donor/grantor annually during

term of trust• Upon termination, the trust fund is paid to the holders of

the remainder– GRAT: income interest is a fixed sum of dollars determined at

the outset of the trust, payable annually– GRUT: Grantor/holder receives amount equal to fixed

percentage of FMV of trust. Percentage is fixed at time GRUT created. FMV of GRUT is determined annually



Charitable Lead Annuity Trusts

• Similar to a GRAT, but charity receives the annuity during the CLAT’s term of years– Remainder passes to donor’s family at a

reduced gift tax value determined at outset of the trust

– Donor receives charitable income tax and gift tax deduction for the annuity



Qualified Personal Residence Trusts• Gifting technique that can be utilized to transfer

house (usually a vacation home – but can be primary residence) to donor’s children at a discounted value– It’s an irrevocable trust to which the house is

transferred and donor reserves right to live in the house for a term of years, with either the children owning the house outright at donor’s death or in trust

– Grantor trust– If house sold, QPRT can be converted to GRAT



ILITS

• Basic planning points– Death benefits held at death

• Allows use of grantor’s gift tax exemption and GSTT exemption amount

• Multiple beneficiaries can have interest in death benefits

• Draft with flexibility in mind

B233



ILITS – Accomplishing Flexibility

• Donor powers– Change beneficiaries that will receive

Crummey powers– Use tiered Crummey powers– Beneficiaries holding contingent remainders

can have a vested interest in ILIT



ILIT Drafting Provisions

• 5 and 5 power applied to entire ILIT• Ordering rule for donee holding mutiple

withdrawal rights• Special powerholder with limited power to

appoint trust property during grantor’s lifetime



Beneficiary Powers

• Testamentary limited powers of appointment in beneficiaries

• Power of grantor, grantor’s spouse and beneficiaries to change trustee



Trustee Powers

• Discretion to satisfy Crummey notice requirements

• Crummey powers satisfied against all trust property

• Allow trustee to appoint guardian for minors likely to receive Crummey withdrawal right



Estate of Turner

• Transferred FLP assets were included in the decedent’s gross estate.

• Court also addressed the issue of whether the decedent’s payment of life insurance policy premiums were subject to the annual exclusion under Section 2503(b).



Estate of Turner

• Sloppy Crummey gifting– Decedent was grantor of irrevocable life insurance trust that had

purchased three separate life insurance policies. – In 2000-2003, the decedent paid the insurance premiums

directly from a joint checking account instead of transferring money to the trustees to pay the premiums.

• IRS included the premiums paid on the life insurance policies in the estate’s total adjusted taxable gifts.

• Tax Court held that the premium payments were a gift of a present interest and were subject to the annual exclusion under Section 2503(b) – beneficiaries had “right to demand withdrawals from the trust”



Corporate Buy-Sell Agreements

• Entity purchase agreement– Contract between stockholders and corporation

• Cross purchase agreement– Contract between stockholders

• Hybrid agreements– Contract between corporation and stockholders

whereby stockholders agree to offer their shares first to the corporation and then to other stockholders

B234



Advantages of Buy-Sell Agreements

• Prevention of the sale of stock outside the family unit

• Relatively simple• Creates a ready market for the stock

– Remedies a liquidity problem– Can help set a value for stock



Disadvantages of Buy-Sell Agreements

• Hybrid type agreement may pose difficult tax issue– Must meet technical requirements of Sec.

302(b) or Sec. 303

• Less tax problems with cross-purchase agreements

B236



Buy-Sell Agreement and Life Insurance

• Provides funds to cover purchase price or down payment– Premiums not deductible and can cause

ongoing expense



Other Post-Mortem Issues

• Buy-out of deceased shareholder’s stock could jeopardize estate’s making Sec. 6166 election– Watch acceleration of deferred taxes

• Planning around this?

• Buy-sell could trigger gift of stock to trust for surviving spouse not to qualify for marital deduction– Rinaldi case



Funding a Buy-Sell

• Life insurance often funds if death is triggering event– Proceeds received by beneficiary without

income tax liability



Funding a Buy-Sell

• Problems with life insurance– If proceeds received by C corporation can

increase C corporation’s AMT liability by increasing C corporation’s current earnings

– May not be sufficient to fund lifetime redemption caused by stockholder’s disability or retirement

B237



Funding a Buy-Sell

• Accumulated earnings– May not be a “reasonable need of the

business” and, thus, could subject corporation to accumulated earnings tax



Funding a Buy-Sell

• Buy enough permanent life insurance to fund post-mortem buyouts, obtain debt financing to pay for stock bought other than at death , with use of excess of postmortem purchase price over insurance death benefit to pay off loan



Income Tax Treatment

• Cross-purchase agreement– Gain is capital gain regardless of character of

corporation’s underlying assets (unless shareholder is dealer in stock)

– If estate sells stock shortly after shareholder’s death, no gain recognized if agreement sets sales price at date of death value

– Purchasing shareholders increase basis in total holdings of corporate stock by price paid for shares purchased via agreement

B236




• Redemption agreement – Must satisfy Secs. 302 or 303 to avoid

dividend treatment• Big potential problem for post-mortem redemptions




• Hybrid agreement– Corporation must redeem only as much stock

as qualifies for sale or exchange treatment under Sec. 303, and other shareholders must buy balance of available stock.




• “Wait and See” agreement– Definition– Alternative approach– Combination for funding




Top Ten Developments in Agricultural Law*

Roger A. McEowen**

________*Presented at the National Farm Business Management Conference, Overland Park, Kansas, June 10, 2013.

**Director, Center for Agricultural Law and Taxation, Ames, Iowa



Contact Information

• [email protected]• (515) 294-5217• www.calt.iastate.edu



Development No. 10• Court tosses out EPA’s pollution rule

– EME Homer City Generation, L.P. v. Environmental Protection Agency, et al. (D.C. Cir. Aug. 21, 2012)

• EPA was in the process of promulgating four new pollution rules to diminish the coal industry

• Court struck down the Cross-state air pollution rule – a cap and trade styled program to expand existing limitations on sulfur dioxide and nitrogen dioxide emissions from coal-fired power plants in 28 “upwind” states.

– EPA claimed it had authority to cap emissions that supposedly travel across state lines– EPA admitted that rule would cost $2.7 billion and force many coal-fired power plants to close.

• Seven states sued and court ruled that EPA exceeded its authority under CAA– Upwind states can only be required to reduce their own significant contributions to downwind state’s

non-attainment, not any more– EPA departed from its own past approach to implementing good neighbor provision

– The litigation could have been avoided, but the U.S. Senate, in 2011 defeated a resolution to nullify the rule

– On Jan. 24, the court denied the Administration’s request for a full court review of the ruling



Development No. 9

• Defined value clause upheld where no charitable beneficiary involved– Wandry v. Comr., T.C. Memo. 2012-88

• IRS revaluation served to reallocate interests in excess of the defined value to the original donor

• Tax Court provided roadmap of points to follow when implementing a defined value clause

• Donors made fixed dollar gifts of family LLC units

– Good approach for gifting business interests of large value and those that are difficult to value



Development No. 8

• Reasonable compensation in the S corporation context– David E. Watson, P.C. v. United States, 668 F.3d

1008 (8th Cir. 2012)• Income can be extracted from S corporation in form of

wages and in distributions (dividends)– Wages are subject to self employment tax– Dividends are not subject to self employment or payroll tax

• Case instructive on what is a reasonable compensation



Development No. 7

• Special use valuation regulation invalidated (again)– Finfrock v. United States, 860 F. Supp. 2d 651 (C.D.

Ill. 2012)• 25% test• IRS regulation created requirement not contained in

statute• IRS regulation invalid even under greater deferential

standard• Important planning implications



Development No. 6

• Pesticide drift not a trespass– Johnson, et al. v. Paynesville Farmers Union

Cooperative Oil Co., 817 N.W.2d 693 (Minn. 2012)• A trespass requires a physical invasion• Can pesticide drift constitute a physical invasion?

– MN Court of Appeals said “yes”– MN Supreme Court reversed

» No evidence presented of whether drift reached EPA threshold of 5 percent

» Must have an intentional and direct physical and tangible entry – spray drift doesn’t count

» Nuisance and negligence appropriate remedies» Plaintiffs caused their own damages



Development No. 5

• Wetlands and Swampbuster– Sackett v. Environmental Protection Agency, 132 S.

Ct. 1367 (2012)• Sec. 404 of Clean Water Act• EPA “compliance order” technique freezes landowner in

place until permit obtained– No right to hearing or ability to get judicial review because

compliance order not “final agency action” – so no appeal rights

– Landowner had no way to force EPA to take action

• Supreme Court unanimously rejected EPA’s argument



Development No. 5

• Swampbuster– Maple Drive Farms Family Limited

Partnership v. Vilsack (W.D. Mich. Dec. 13, 2012)

• 2.24 acre tract drained in 1964 and crops grown through 1982

• Drainage deteriorated• Plaintiff later wants to again grow crops• Status of land as of December 23, 1985 controls



Development No. 4

• Chapter 12 Bankruptcy Taxation– Hall v. United States, 132 S. Ct. 1882 (U.S.

2012)• 2005 BAPCPA provision

– Not applicable to post-petition taxes because no separate bankruptcy estate from the debtor

– Pre-petition taxes covered by the new rule



Development No. 3

• Constitutional Takings Developments– The Edwards Aquifer Authority v. Day, 369

S.W.3d 814 (Tex. 2012)• Groundwater and oil and gas deposits are subject

to the rule of capture• Historic use – what if groundwater hasn’t been

used in the past?• Land ownership includes “in-place” groundwater



Development No. 3

• Arkansas Game & Fish Commission v. United States, (U.S. Sup. Ct. Dec. 4, 2012).– Recurrent flooding, even of finite duration, are

not categorically exempt from Takings Clause liability



Development No. 2

• Individual mandate provision of health care law upheld as “tax”– National Federation of Independent Business

v. Sebelius, 132 S. Ct. 2566 (2012)• Individual mandate unconstitutional under the

Commerce Clause• It is constitutional as a tax



Development No. 1

• Uncertainty caused by expiring tax legislation– House passed H.R. 8 during summer 2012, but

Senate refused to take it up until later December 2012– Delay created major uncertainty in tax, estate and

business planning– New law makes “permanent” many provisions of the

2001 law– Tax increase for all wage earners and other “high”

income taxpayers



• The article detailing all of these developments from 2012 can be found on the CALT Website homepage– www.calt.iastate.edu



Trusts and Passive Income

• The IRS view is that only the trustee, acting in its capacity as trustee, can satisfy the material participation test for a trust– No regulations– The one court that has decided the issue said the

IRS position is “arbitrary, subverts common sense, and attempts to create ambiguity where there is none”

– Tax Court case pending.



Life Insurance Demutualization

• Dorrance (D. Ariz. Mar. 19, 2013)– Plaintiff’s basis in stock comprised of fixed

component for giving up voting rights and 60 percent of variable component representing past contributions to surplus

• Basis was slightly over 60 percent of stock value

9-10



Life Insurance Demutualization

• Reuben v. United States, No. CV 11-09448 SJO (PJWx) (C.D. Cal. Jan. 15, 2013)– Plaintiff failed to establish that any of the premiums paid were

for membership rights in insurance company• Consequently, plaintiff did not have an income tax cost basis in share

of stock issued on demutualization when shares eventually sold in 2005

• Plaintiff failed to offer evidence of purchase price paid for membership rights in particular as opposed to policy as a whole; thus, plaintiff failed to satisfy proof burden that income tax basis other than zero.

• Facts of case distinguishable from those in Fisher, et al. v. United States, 82 Fed. Cl. 780 (2008)).




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