SOME VALUATION OBSERVATIONS RELATING TO LLC INTERESTS

A recent Tax Court case addressed some interesting issues relating to the estate tax value of an LLC interest. Below is a summary of these issues.

A. Valuation of An Interest as a Full Member Interest or an Assignee Interest. The operating agreement for the LLC interest provided that if an LLC interest is transferred outside of the family, the new owner is a mere assignee that cannot participate in management unless all of the other members vote to admit the new owner as a full member. At the time of the decedent’s death, the LLC interest at issue was owned by a trust, and included in the decedent’s gross estate via Code Section 2038. The interest in the hands of the trust was a full member interest.

The estate sought to value the transferred interest as an assignee interest only. The Tax Court declined, and said it should be valued as a member interest because that is what it was immediately before death. Nonetheless, since a buyer would consider the restrictions on transfer in the operating agreement in determining what it would pay, such nonfamily/assignee restrictions should still be a factor in the final valuation.

B. Net Value vs. Income Approach. The estate sought to value its LLC interest based on the historical distributions made to its members (i.e., an income approach), especially because it wanted to characterize the LLC as an assignee interest that could not participate in management.

The IRS instead valued the LLC interest based on a net asset value approach – valuing the assets of the LLC, deducting LLC liabilities, and then multiplying that net value by the percentage of the LLC attributable to the subject LLC interest.

Note that both approaches are the starting point for valuation – once a preliminary value for the interest is obtained then appropriate discounts for lack of control and lack of marketability as to the LLC interest are applied.

The court noted that a net asset method of valuation applies to mere holding companies since they are not managed for current income, while an earnings-based method applies to going concerns. It also noted a mixed net value and income/distribution capitalization approach has been applied in other cases for a closely held real estate firm. While the court did acknowledge that the rental of the LLC’s real estate constituted an operating business and thus suggested some focus on historical distributions to members, it applied the net asset value approach for the value of the LLC interest (even though the real estate itself had been valued using an income approach) – this was done partly because no evidence appears to have been accepted into evidence as to those values. Cases cited by the Tax Court for applying a mixed valuation approach were  Estate of Andrews, 79TC 938 (1982) and Estate of Weinberg v. Commissioner, T.C. Memo. 2000-51. Thus, the case does not foreclose a mixed approach in general – just under the lack of evidence presented in this case.

C. It Can Be Difficult for a Taxpayer to Claim a Lower Value than Originally Reported. Here, the estate argued for a valuation lower than the value it reported on the estate tax return. This is often a negotiating tactic for estates on audit, and at other times such assertions of lower values are wholly bona fide after a different set of professionals review the initial reporting. The Tax Court was resistant, noting:

"[V]alues or discounts reported or claimed on an estate tax return may be considered admissions and, to some extent binding or probative, restricting an estate from substituting a lower value without cogent proof that those admissions are wrong.” Estate of Deputy v. Commissioner, T.C. Memo. 2003-176 [TC Memo 2003-176], 2003 WL 21396789, at *5 n.6; accord Estate of Hall v. Commissioner, 92 T.C. 312, 337-338 (1989). We have no cogent proof that the value that petitioner relied on in reporting the value of the subject interest on the Schedule G is wrong.

Estate of Diane Tanenblatt, et al. v. Commissioner, TC Memo 2013-263

RECORDING OF MORTGAGE NECESSARY FOR QUALIFIED RESIDENCE INTEREST DEDUCTION

Two individuals borrowed money from the mother of one of them. A mortgage was prepared to secure the debt, but it was not recorded in the public records.

Oftentimes, mortgages are not recorded between friends and family. They will allow the holder to foreclose on any debt defaults, so they still provide protection to the lender. However, other lenders are not on notice of the debt and thus the mortgage may be subordinated to later mortgages and security interests.

The borrowers sought to deduct interest that they paid to the lender.  Code Section 163(h) prohibits an interest deduction for personal interest, but provides an exception for qualified residence interest.  The statute requires that to be qualified residence interest, the debt must be “secured by the residence.”

The taxpayers asserted that an unrecorded mortgage still secures the related debt. What beat the taxpayers here was Treas. Regs. § 1.163-10T(o)(1), which requires that a mortgage be “recorded, where permitted, or is otherwise perfected in accordance with applicable State law.” Thus, the Tax Court denied the deduction, and thus reminds taxpayers that if they want an interest deduction in these situations, they will need to record the mortgage.

Christopher DeFrancis and Jennifer Gross v. Commissioner, T.C. Summary Opinion 2013-88

FILING A PROBATE CLAIM MORE THAN 90 DAYS AFTER PUBLICATION IF NOTICE TO CREDITOR NOT RECEIVED [FLORIDA]

Under Florida law, a creditor cannot file an effective claim against an estate more than 3 months after publication of the Notice to Creditors, UNLESS the creditor is a known or reasonably ascertainable creditor that was not sent a Notice to Creditor. Therefore, such a known or reasonably ascertainable creditor that has not received notice can file a claim more than 3 months after the publication date, so long as it is not more than 2 years after death of the decedent (per the absolute 2 year deadline of Fla.Stats. Section 733.710).

Can such a creditor directly file a claim, or does the creditor also have to file a motion for leave to file a later claim within the 2 year period? In Morgenthau v. Estate of Andzel , 26 So.3d 628 (Fla. 1 st DCA 2009) and Lubee v. Adams, 77 So.3d 882 (Fla. 2d DCA 2012), two District Courts of Appeals require that the motion be filed to trigger a court review whether the creditor is a known or reasonably ascertainable creditor that should have received notice – the mere filing of the claim is not enough. Now, along comes a new case, Golden v. Jones, 2013 WL 5810360 (4th DCA 2013), which provides that the motion is not required.

Legislative relief on the need to file such a motion may be forthcoming. But until it does, or unless the Florida Supreme Court resolves the split among its Circuits, creditors outside the 4th DCA should nonetheless file the motion to protect their late filed claims.

For additional write-ups on the case, see Rubin on Probate Litigation (Jenna Rubin) and the Probate and Trust Litigation (Juan C. Atunez) blogs.

Golden v. Jones, 2013 WL 5810360 (4th DCA 2013

INFLATION ADJUSTED TABLES

I’ve been putting these tables together since 1990 – formerly on paper and mailed out, now on our firm’s website. Below are the updated 2014 tables with the recent inflation adjustments.

You can access these charts whenever you want here, or from the link in the links section on the right. Since it is a good idea to glance at these things at least once a year, I have also reproduced the federal items below to make that task easy for you (you will need to click the link to see the Florida items).

DYNASTY TRUSTS–FOOD FOR THOUGHT

A regular part of planning for high net worth families are dynasty trusts – long term multi-generational trusts that are exempt from generation skipping tax. The trusts are more attractive than ever, with expanded generation skipping tax exemptions ($5.25 million in 2013) and an extended or eliminated rule against perpetuities provisions in many states.

The typical thought is that these trusts will grow and service many generations of beneficiaries. Hugh Magill, the Executive Vice President and Chief Fiduciary Officer of Northern Trust has combined Northern Trust’s data from its many years of trust administration and some modeling, and gleaned some observations about how such trusts actually operate, and might operate in the future. Some of his observations (mixed in with a few of my own) that may challenge your assumptions about dynasty trust include:

A. The number of beneficiaries will multiply faster than you think. With some reasonable assumptions about child-bearing ages and  each family unit having two children, in 50-60 years time a pot trust could have as many as 30 current beneficiaries.  As time progresses, the number increases potentially so that if a trust lasts for a very long time (as some may anticipate), it could have as many as 160,000 to 500,000 beneficiaries! As Hugh speculates, who would want to be trustee of that trust?! Obviously, the more beneficiaries there are, the quicker the trust will be depleted (depending on distribution standards used). Having an early termination of the pot trust via a break up into separate per stirpes trusts will reduce this, but will still result in continual subdivision and shrinkage of each trust as they pass through the generations. Hugh also raises the question of fairness – at what generation level would it be more equitable for a pot trust to divide per capita (equally per beneficiaries) rather than per stirpes?

B. Applying some Monte Carlo modeling and assumptions, a median result for a $5.25 million dynasty trust established in 2012 estimates growth to $9.8 million in 2029, and then it starts to decline, reaching $4.1 million in assets by 2071. However, these are 2012 dollars – if inflation is considered, that $4.1 million will be worth much, much less than $4.1 million in today’s dollars.

C. If the trust is a grantor trust, that will boost the return somewhat since it will have a few years of not being taxed at the beginning of its life, but that treatment ends when the grantor dies. This treatment augments the median value estimate to $5.3 million in 2071.

D. Note, however, that these projections involve a diversified portfolio of marketable assets and securities. If the trusts are funded with discounted assets and/or highly appreciating assets, the growth of the trust and its size over time can be substantially increased.

E. Payout standards will also impact how long the trust will maintain significant assets – obviously, the more that is paid out in distributions, the fewer the assets that will remain and grow in the trust. Planners may want to consider scaling back from mandatory income, significant unitrust, and/or HEMS distributions after a generation or two to help the trust maintain its assets – perhaps limiting distributions to health and education purposes.

The fact that a dynasty trust may not last as long as originally anticipated may not be of much concern to many grantors. While there are those grantors who are looking to carry the trust as far into the future as possible (especially in very high net worth families), many grantors will not even have known what a dynasty trust is when they first walk into their lawyer’s office. Such grantors will often have no problem with such trusts exhausting themselves sooner, rather than much later.

Thanks to Hugh Magill for his work and observations, and his permission to me to attempt to restate them here – and my apologies in advance to Hugh if I have incorrectly summarized any of his points.

COMMUNITY PROPERTY INCOME NOT SHARED FOR SELF-EMPLOYMENT TAX PURPOSES

A recent Tax Court case illustrates a trap for the unwary in regard to the computation of self-employment taxes.

Spouses subject to community property laws obtain an interest in the assets and income of their spouses. Unlike what one might expect, this “sharing” does not apply, however, in regard to self-employment tax computations.

Self-employment taxes are based on net earnings from self-employment. Code §6017 expressly provides that for a husband and wife filing a joint return, the income is not aggregated for purposes of computing the tax, but computed separately.  That section is silent as to community property income. However, Code § 1402(a)(5) specifically addresses community income in defining net earnings – the general rule is that income and deductions will be attributed to the spouse carrying on the trade or business (but it will be shared if the spouses jointly carry on the business).

In the case, the wife tried to use the losses from the husband’s accounting practice to offset the income from her realty business for self-employment tax purposes. The Tax Court did not allow it, based on the foregoing provisions.

Donald and Brenda Fitch, TC Memo 2013-244

SALE FOR ANNUITY RESULTS IN §2036 INCLUSION

In a recent Tax Court case, a decedent had sold properties to trusts in exchange for fixed annuity payments. The decedent died during the term of the annuities, and the IRS sought to include the value of the transferred properties in the decedent’s gross estate under Code §2036. The IRS was able to prevail.

The estate argued that the transfers of the properties to the trusts avoided Code §2036 by constituting “bona fide sales for adequate and full consideration.” The Court ruled against this argument for several reasons:

    a. The decedent did not receive adequate and full consideration since the present value of the annuity payments did not equal the value of the property transferred - i.e., there was a gift element to the transfer.

    b. There was no “bona fide” sale in an arm’s length transaction sense, since the decedent prepared the trust agreement in the absence of meaningful negotiation or bargaining with other cotrustees or future beneficiaries. The decedent formed the transaction, fully funded the trust, and essentially stood on both sides of the transaction.

    c. An argument, borrowed from transfers to partnership cases, that the transaction qualified for sale exception due to nontax purposes for the transaction failed. It first failed because the Tax Court did not equate this type of transfer with a transfer to a partnership where nontax purposes are a relevant aspect. It also found as a factual matter that there really were no nontax purposes for the transaction.

The estate also argued that the decedent had not retained an interest in the property under Code §2036 - i.e., that there was no “express or implied agreement at the time of transfer that the transferor will retain lifetime possession or enjoyment of, or right to income from, the transferred property.” A provision in the annuity trust agreement allowed for additional income to be distributed to the decedent at the direction of the trustees. There were 3 trustees - the decedent and two children. The court noted that “because decedent and her children could make distributions of additional income to decedent when and in the amount they pleased, decedent maintained the same enjoyment of the properties and their income stream as she had before she transferred the properties to the annuity trust.” This fact (notwithstanding Byrum), combined with the decedent’s continued control over the transferred property per how the trust was operated, and the use of the income from the properties to discharge her personal legal obligations, was enough for the court to find a Code §2036 retention of interest.

The estate nonetheless argued that the transaction was a bona fide sale for an annuity, and thus the decedent did not retain an interest in the property that was transferred but simply exchanged it for an annuity. The Court noted that in Ray, 762 F2d at 1363, that a sale for an annuity would not be respected as such when “(1) the property the taxpayers transferred to the trust was, in effect, the only source for their “annuity” payments; (2) since the trust's income was designed to equal the annual payments to the taxpayers,  the “annuity” payments would not be paid from the trust corpus; and (3) the trust corpus would be available for “ultimate distribution to the trust beneficiaries.”  By contrast, “a sale in exchange for an annuity occurred where the parties structured the transaction as an annuity obligation, the amount of the annuity did not bear a mathematical relationship to the trust income, the transferor did not control the property transferred, and the trust corpus was used to pay the annuity rather than simply providing for annuity payments as a conduit for the trust income.” The court held that the facts of this case more closely resembled the earlier “no sale” factors then the later “sale” factors.

Estate of Helen A. Trombetta et al. v. Commissioner, T.C. Memo. 2013-234

STATE BUSINESS TAX CLIMATE DIAGRAM–WHERE DOES YOUR STATE FIT IN?

Florida comes in at a very respectable #5. Woe to those in the bottom three – California, NY, and NJ.

Go here for a more readable version of the diagram and other background information.

UPDATED HISTORICAL FEDERAL TRANSFER TAX RATES, EXEMPTIONS, AND RELATED INFORMATION TABLE

In Rev. Proc. 2013-35, the IRS has published inflation-adjusted amounts to various taxes, exemptions, and other items. The unified credit basic exclusion amount for transfer tax purposes, along with the GST tax exclusion, has been increased to $5.34 million.

I have updated my historical table of transfer tax rates to include 2014 – a copy can be viewed and downloaded from here. It can also be accessed at any time from the list of links in the right hand column. I keep a copy under the glass of my desk since questions about a particular rate or exemption from a prior year always come up.

For those with an interest in the full list of inflation adjusted items, click here for Rev.Proc. 2013-35.