The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Please send address corrections to firstname.lastname@example.org. © 2015 Pepper Hamilton LLP. All Rights Reserved. This publication may contain attorney advertising 500+ 13 125 lawyers offices in U.S. years of serving clients Client Service A-Team Highly ranked by clients in BTI consulting Survey Update TRUSTS AND ESTATES Vol. 2015, Issue 1 Richard Schwartz Elected to Partnership Page 11 IN THIS ISSUE Estate Tax Controversy Continues Page 9 The Time to Transfer Entity Interests Is Now Page 2 Did You Create a Grantor Trust? Page 4 Addressing the Residency Question Page 6 2 The Time to Transfer Entity Interests Is Now Upcoming IRS regulations may significantly limit and reduce planning opportunities to transfer minority interests in closely held entities to family members and increase the transfer tax cost associated with moving such interests. The Internal Revenue Service (IRS) is preparing to significantly limit the availability of an important tool used to transfer minority interests in certain partnerships, corporations or limited liability companies to family members. Valuation discounts have long been a powerful means to transfer assets to family members at a significantly reduced transfer tax cost. Generally, the value of a minority interest in an entity transferred to family members would be discounted for “lack of control” and “lack of marketability” because of the minority owner’s inability to exercise any control over the entity or freely transfer the interest for a proportionate share of the entity’s fair market value. The IRS has long attacked these discounts through the courts and through proposed legislation. Now, after losing most of those battles, the IRS is about to take matters into their own hands by issuing regulations to restrict the use of valuation discounts. 3 Internal Revenue Code (IRC) § 2704 disregards certain restrictions that apply to a family-owned entity for purposes of valuing the interests in the entity. This section does not specifically address discounts. However, in enacting IRC § 2704 in 1990, Congress provided the Department of the Treasury with the authority to issue regulations that would further specify the types of restrictions that will be disregarded. No regulations have been issued to date, but it is strongly rumored that new regulations will be released in summer or fall 2015, and the speculation is that these regulations will contain a significant restriction on the ability to use valuation discounts to transfer entity interests to family members. Although the details of the proposed regulations remain unknown, they are likely to target a variety of perceived abuses resulting from the discounting of entity values. Potential targets of the regulations include the following: • eliminating discounts related to entities that hold only cash and marketable securities • disallowing a lack of control discount for any entity that is controlled by family members before and after the transfer • disregarding certain “nontax reasons” (e.g., centralized investment management and control, creditor protection, etc.) that have served as the justification for using family entities and taking discounts for transfers of the minority interests. The details of the regulations will be made known shortly. For now, we can be fairly certain that the new regulations will significantly limit and reduce planning opportunities to transfer minority interests in closely held entities to family members and will increase the transfer tax cost associated with moving such interests. If you are considering transferring interests in your business entity or family partnership to family members, we urge you to contact us to discuss the options that are currently available so that any transactions can be implemented before the anticipated regulations are issued. 4 Did You Create a Grantor Trust? Because of the increases to the income tax rates and the reduction in the estate tax rates in recent years, anyone holding appreciated assets in a grantor trust should consider exchanging high-basis assets that have less appreciation potential for the appreciated assets in the trust. Many of our clients have created “grantor trusts” for their family and transferred appreciating assets to the grantor trust to attempt to reduce or limit their estate tax exposure. In these cases, the grantor trust was used to avoid estate taxes while retaining the income tax liability for the grantor (or creator) of the trust. This technique has the added advantage of requiring the grantor to further reduce his or her estate by paying the income tax liability on the assets that were transferred to family members without such payments being treated as gifts. A common technique used to qualify the trust as a grantor trust was to provide the grantor of the trust with the power to take back some or all of the assets that are currently in the trust, so long as the grantor transfers assets to the trust with an equivalent value. For instance, if the grantor transferred closely held business stock or real estate to the trust and now wishes to own those assets in his or her individual name, the trust allows the grantor to transfer other assets to the trust having an equivalent value in return for taking back the stock or real estate. Although there are reasons a grantor may not want 5 to return those assets to his or her estate, such as subjecting them to valuation concerns with the taxing authorities, there may be a significant income tax benefit to doing so. The general income tax rule is that, when an asset is transferred to a trust during the grantor’s lifetime, the trust receives the grantor’s income tax basis in the transferred asset. Often, the transferred asset has a very low basis. Thus, the sale of the asset will trigger a large capital gain, even if the asset is sold after the grantor’s death. Instead, if the asset were to be owned by the grantor at death, the asset would receive a tax basis equal to the asset’s fair market value at the time of the grantor’s death. As a result, if the recipient sells the asset for its fair market value after the grantor’s death, there will be little or no income or capital gain tax to be paid. Because of the increases to the income tax rates and the reduction in the estate tax rates in recent years, anyone holding appreciated assets in a grantor trust should consider exchanging high-basis assets that have less appreciation potential for the appreciated assets in the trust. This is of particular concern to clients who do not plan to have the trust assets sold during their lives, but who expect that they will be sold after their deaths. As with all tax planning techniques, this plan is not right for everyone. If you are interested in more information about how this would work or whether it is right for you, please contact us. 6 Addressing the Residency Question Generally, the first criterion for determining whether an individual is subject to probate or to estate or inheritance tax in a state is the individual’s domicile at the time of his or her death. In an increasingly complex and shrinking world — with job opportunities becoming more portable, children moving to other locales to seek those opportunities and parents following along (or elderly parents moving to live near or with their children), and people escaping to warm-weather climates for large parts of the year — we are seeing the issue of residence and domicile for estate tax and income tax purposes coming up more frequently. Add to this the fact that states (especially in the Northeast) are looking for tax revenues wherever they can find them, and you have a recipe for dueling states looking for tax revenues from the same people. There is often a significant difference between the taxes inherent in living or working in different states, so the question of residence or domicile requires some thought and planning. For income tax purposes, the residency requirement is generally based on objective criteria, such as the number of days you reside in a particular state in a given year. For example, many state laws provide that you are a resident of the state if you spend more than 183 days in the state during the year. If an individual does not spend more than 183 days in any one state during the year, more than one state may claim that individual as a resident, causing them to potentially owe tax in two or more states. Often, your accountants will help you determine your residency for income tax purposes based on these objective criteria. 7 Generally, the first criterion for determining whether an individual is subject to probate or to estate or inheritance tax in a state is the individual’s domicile at the time of his or her death. A domicile is where one intends to make his or her home for a permanent or indefinite period. A taxpayer can have only one domicile. Once domicile is established, it continues until it is established elsewhere. If one moves temporarily, without establishing domicile in another state, domicile continues to be in the state where domicile was established. Many factors are used to determine domicile. Please note that no single factor will determine the state of domicile. All relevant factors are evaluated. Below is a list of some of the factors that are considered in making domicile determinations. Property Ownership and Residence • the location of your principal residence • your mailing address • where you spend the most amount of time • where you applied for a homestead or veterans property tax exemption or other comparable benefit. Family and Dependents • whether you can be claimed as a dependent on another person’s federal income tax return and where that person is domiciled • where your spouse or close family members reside. Licenses and Registrations • where you are registered to vote • which state issued your driver’s license • where your vehicles are registered • where you maintain professional licenses • where you declare residency for hunting and fishing licenses. 8 Financial Data • the state where active bank accounts or loans are located • the state where you qualify for unemployment insurance • the state in which you filed previous resident tax returns • the state where you earn your wages • the address recorded for insurance policies, deeds, mortgages or other legal documents, such as your will • the state where you maintain safe deposit boxes. Affiliations • the state in which you hold fraternal, social or athletic memberships • the state where you maintain union memberships • the location of a church or other house of worship of which you are a member or generally attend services. Other Factors • where your valuable personal property (art, antiques, jewelry, etc.) is located • where you conduct your business • the address listed for you in a telephone directory • where you keep your pets • the location of your personal physician or where you have been admitted to a hospital for nonemergency treatment. Even if an individual is domiciled in one state, his or her heirs may still need to pay estate or inheritance taxes or probate a will in another state. This situation generally arises if the individual owns real property in a state that is not his or her state of domicile. Proper planning may avoid the need for a separate probate in those other jurisdictions. Please contact any one of us if you would like to discuss your particular situation. 9 Estate Tax Controversy Continues Recently introduced bills are indicative of the fact that the estate, gift and generation skipping transfer taxes are still a topic of considerable political debate. Recently, the Responsible Estate Tax Act was introduced in both the House and the Senate. This bill, if enacted into law would significantly increase and modify the estate, gift and generation skipping transfer (GST) tax system. Highlights of the proposed changes include the following: • increasing the tax rates to include a top bracket of 65 percent (for estates of more than $500 million) • reducing the exemption amount for estate and GST tax to $3.5 million, and reducing the gift tax exemption to $1 million • introducing new rules regarding grantor retained annuity trusts that would significantly impair the efficacy of the technique • limiting the gift tax annual exclusion in certain circumstances. 10 Earlier this year, two separate bills — the Simplified, Manageable, and Responsible Tax Act and the Death Tax Repeal Act of 2015 — were introduced in both the House and the Senate with the intention of repealing the estate, GST and, with respect to the former, gift taxes. In addition, there have been numerous other estate tax repeal bills introduced in the House this year. Although it is unlikely that any of these proposed bills will become law (especially prior to the 2016 election), the various contrasting bills are indicative of the fact that the estate, gift and GST taxes are still a topic of considerable political debate, and the “permanent” law enacted in 2013 may, like most things in life, be only temporary. 11 Berwyn | Boston | Detroit | Harrisburg | Los Angeles | New York | Orange County | Philadelphia | Pittsburgh Princeton | Silicon Valley | Washington | Wilmington Richard Schwartz Elected to Partnership We are pleased to announce that Richard M. Schwartz was elected to the partnership of Pepper Hamilton LLP effective January 1, 2015. Rich joined the firm in 2004 and has been a valued member of our team ever since. We look forward to Rich’s continuing leadership and contributions to the Trusts and Estates Group. Rich concentrates his practice on trust, estate and business succession planning. He advises owners of closely held businesses, executives and families of significant wealth on complex matters involving income, estate, gift and generation skipping transfer taxes; estate and trust administration; and general family and business issues. Berwyn | Boston | Detroit | Harrisburg | Los Angeles | New York | Orange County | Philadelphia | Pittsburgh Princeton | Silicon Valley | Washington | Wilmington www.pepperlaw.com Berwyn Boston Detroit Harrisburg Los Angeles New York Orange County Philadelphia Pittsburgh Princeton Silicon Valley Washington Wilmington www.pepperlaw.com MARKING A MILESTONE Since 1890, the lawyers of Pepper Hamilton have been committed to the values established by our founders, including respect for the rule of law, zealous advocacy of each client’s cause, and ensuring excellence in all that we do. Visit www.pepperlaw.com/timeline for a brief overview of our proud history.