Estate Planning is hard to talk about. Do you really want to talk about death and taxes? But Estate Planning is also about life-your legacy in this life-and the lives of your children and lives of your grandchildren after you are long gone. Not to mention the tax free estate tax reducing gifts you give to all your children while you are living and enjoying life. Furthermore, with a custom estate plan, your children and grandchildren can be protected in this life, as you perhaps have been protected if your parents had wisely estate planned in their lifetime. A good estate plan will not only secure and protect your family from harm’s way, but also prevent you all from being taxed to death by excessive estate tax so high your kids might just have to sell the farm to pay your death taxes. So if you are interested in protecting your family-and your assets-for generations to come, stay with us here on TaxView with Chris Moss CPA Tax Attorney and find out how you all can create the perfect Estate Plan for your family.
Let’s start your Estate Plan with gifting. You can actual gift assets to reduce your estate tax to each child and grandchildren up to $14K or $28K married each year tax free. But what if you gift over the $28K annual exclusion? Current law in 2015 allows you a one-time exclusion a $5.43 Million dollar limit in your lifetime-$10.86 Million married. But be warned: this lifetime exclusion is subject to Congressional reform just about at any time during any administration. If you gift over the lifetime exclusion you are taxed at 40% on the overage as the Cavallaro family found out in Cavallaro v IRS US Tax Court (2014).
Cavallaro started out in 1979 and grew the company with his three sons into Camelot Systems and Knight Tools both operating out of the same building. In 1994 Ernst &Young (E&Y) was retained to consider an estate plan for Cavallaro. They suggested a merger of both Knight and Camelot. Unbeknownst to E&Y, Cavallaro also retained attorneys Hale & Dore of Boston for estate planning. Mr. Hamel of that firm claimed that much of Camelot was already owned by the three sons based on a one-time transfer made in 1987 to the sons in exchange for $1000 from all three sons.
When E&Y found out about Mr. Hamel’s plan, senior partners in E&Y immediately pointed out that the 1987 transfer was at odds with all the evidence and E&Y would not support this tax strategy. Unfortunately for Cavallaro, the attorneys eventually prevailed and the accountants acquiesced. Gift tax returns were filed after the merger showing no taxable gifts and no gift tax liability.
In 1998 the IRS audited the business returns for 1994 and 1995 eventually claiming that gifts from parents to children as a result of the merger were grossly undervalued in the gift tax returns Form 709 filed in those years of the merger. The IRS issued third party summonses to E&Y. The tax attorneys filed petitions to quash the summonses fighting all the way to the Court of Appeals for the First Circuit, but eventually lost on all counts.
The Court denied Cavallaro’s motion to quash and ordered the summons enforced as per Cavallaro v United States 284 F.3d 236 (1st Cir 2002) affirmed 153 F. Supp. 2d 52 (D. Mass 2001). As the Court noted there was no attorney client privilege with a CPAs. Therefore all documents had to be handed over to the Government and the E&Y accountants had to testify in many cases against their client’s best interest in compliance with the Court Order. Cavallaro appealed in Cavallaro v IRS US Tax Court (2014) and claimed the gift was at arm’s length. After hearing all the witnesses and reviewing the documents, Judge Gustafson opined that the 1995 merger transaction was notably lacking in arm’s length character, and concluded that the gift was undervalued by Cavallaro. The Court then ruled that Cavallaro made gifts totally $29.6M in 1995 when the two businesses merged handing Cavallaro a tax bill of $12,889.550. IRS wins Cavallaro loses.
Another case Estate of Rosen v IRS (2006) brings us to the next key component of gifting: control. Unless you lose control of the assets you gift, the assets unfortunately still remain in your taxable estate upon your passing. The facts in the Rosen case are simple. Her assets were mostly stocks, bonds, and cash. Her son-in-law formed a family limited partnership in 1996 and the children signed a partnership agreement and a certificate of limited partnership was filed with the State of Florida. Each of the children were given a .5% interest and the Lillie Investment Trust was formed to own a 99% interest. $2.5 million was transferred from Rosen to the Lillie Investment Trust as consideration for its 99% interest.
What is interesting is the partnership conducted no business and had no business purpose for its existence other than to save taxes. When Rosen died the IRS audited sending the Estate over a $1 Million tax bill, claiming all the money in the partnership was includable in Rosen’s estate because Rosen controlled until her death the possession or enjoyment of, or the right to the income from the assets. The Estate of Rosen appealed to US Tax Court in Estate of Rosen v IRS (2006) claiming that Section 2036(a)(1) does not apply because the assets were transferred in a bona fide sale for full and adequate consideration. Alternatively the Estate argued that Rosen did not in fact retain enjoyment or “control” of the assets while she was alive.
Judge Laro observes that the US Tax Court has recently stated, a transfer of assets to a family limited partnership or family limited liability company may be considered a bona fide sale if the record establishes that: (1) The family limited partnership was formed for a legitimate and significant nontax reason and (2) each transferor received a partnership interest proportionate to the fair market value of the property transferred citing the Estate of Bongard v. Commissioner, Estate of Strangi v. Commissioner, Estate of Thompson v. Commissioner, US Tax Court on remand, and Thompson v. Commissioner on Appeal 382 F.3d 367 (3d Cir. 2004)
The Court concluded that the overwhelming reason for forming the partnership was to avoid Federal estate and gift taxes and that neither Rosen nor her children had any legitimate and significant nontax reason for that formation. In addition Rosen herself used the partnership to pay for her personal expenses all the way up to her death and therefore never truly “gifted” the assets out of her estate. IRS wins, Rosen Loses.
So how do you safely start gifting so that your assets are permanently out of your taxable estate in a protected Estate Plan? First create an Estate Plan that has a legitimate business purpose in mind. Second, make sure you have sufficient assets to live without the Family LLC having to support you. Third make sure you have transferred control of these assets to your children with properly filed gift tax returns. Finally, with the help of your tax attorney make sure all transactions are contemporaneously documented with appraisals inserted into the gift and personal tax returns before you file. When the IRS comes to examine your Estate Plan your children will be happy you did.
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Chris Moss CPA Tax Attorney