1 schwabe, williamson & wyatt’s real estate and business seminar series tax saving strategies...

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Schwabe, Williamson & Wyatt’s

Real Estate and Business Seminar Series

Tax Saving Strategies forApartment Building Owners

March 8, 2006Seattle, WA

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IMPORTANT NOTICE

To comply with IRS regulations, we are required to inform you that this presentation, if it contains advice relating to federal taxes, cannot be used for the purpose of avoiding penalties that may be imposed under federal tax law. Any tax advice that is expressed in this presentation is limited to the tax issues addressed in this presentation. If advice is required that satisfies applicable IRS regulations, for a tax opinion appropriate for avoidance of federal tax law penalties, please contact an Schwabe attorney to arrange a suitable engagement for that purpose.

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Our Goals Today

• Learn several tax saving strategies

• Understand why and how each strategy works

• Know the pros and cons of each strategy

• Learn to avoid or minimize risk of IRS audit

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Overview of Current Tax Regime

Federal Estate Tax

Year of Death Federal Estate Tax Exempt Amount

2006 $2 million

2007 $2 million

2008 $2 million

2009 $3.5 million

2010 Repeal (no tax)

2011 and After $1 million

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Overview of Current Tax Regime

Federal Gift Tax

Year of Death Federal Estate Tax Exempt Amount

Federal Gift Tax Exempt Amount

2006 $2 million $1 million

2007 $2 million $1 million

2008 $2 million $1 million

2009 $3.5 million $1 million

2010 Repeal (no tax) $1 million

2011 and After $1 million $1 million

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Overview of Current Tax Regime

Washington State Estate Tax

Year of Death Federal Estate Tax Exempt Amount

Federal Gift Tax Exempt Amount

Washington Estate Tax Exempt Amount

2006 $2 million $1 million $2 million

2007 $2 million $1 million $2 million

2008 $2 million $1 million $2 million

2009 $3.5 million $1 million $2 million

2010 Repeal (no tax) $1 million $2 million

2011 and After $1 million $1 million $2 million

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Harry and Sally’s Family Tree

Harry Sally

JenniferJake Mary Julie MarkDavid

Jason Justin Emma Claire Eva Alex

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Harry and Sally’s Assets

Asset Value

Home $700,000

Apartment A $3,000,000

Apartment B $3,000,000

Apartment C $3,000,000

Other Assets $300,000

Total Assets $10,000,000

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Simple Will

Harry’s Share

$5 Million

Sally’s Share

$5 Million

Case #1No Tax Planning (Simple Wills)

Harry and Sally’s Estate

$10 Million

Harry Dies

Sally Dies

(all subject to taxes)

Sally’sEstate

$10 Million

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State Credit Shelter Trust

$2 Mil

Fed Credit Shelter$1.5 Mil

Marital Trust$1.5 Mil

Harry Dies

Harry’s Share

$5 Million

Sally’s Share

$5 Million

Sally Dies

1/3

Julie’s

Share

1/3

Jennifer’s

Share

1/3

Jake’s

Share

Harry and Sally’s Estate

$10 Million

Case #2Basic Estate Tax Planning

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Pros: Cons:• Saves substantial taxes

• Ensures first spouse’s estate goes to intended heirs

• Do not need to set up trusts during lifetimes of both spouses

• Must be included in Wills prior to first spouse’s death

• Somewhat more expensive to prepare Wills with Credit Shelter Trusts

• Requires trust administration

Case #2Basic Estate Tax Planning

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Member and Co-Manager

Member and Co-Manager

Case #3Family LLC Structure

Harry50%

Sally50%

Apartment A, LLC

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Case #3Discounts of LLC Interests

• Lack of marketability– 30% to 35%

• Lack of control– 44% (Trusts & Estates)

• ¼ exceeded 60%!

• Rev. Ruling 93-12– IRS “throws in the towel”

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Case #3Family LLC Strategy

Apartment A

$3 MillionOwned by Harry andSally Jointly

All three apartmentsTotal: $9 million

Apartment A, LLC

Harry50%

Sally50%

Discounted Value @ 35%$1,950,000

All three LLCsTotal: $5,850,000

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What, me worry?

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Family LLC

Strangi Than Fiction

• $11 million transferred to FLP

• Strangi died two months later

• Heirs claimed 40% discount

• RESULT: Taxed on the full $11 million!

WHY?

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Family LLC

Strangi Than Fiction

• Waited too long (two months before death)

• Transferred too much to FLP (did not retain enough for Strangi’s needs)

• FLP paid Strangi’s bills

• FLP did not conduct any active business

• THE “SNIFF” TEST:Did the parties actually do what they said they would do?

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Family LLC

Tips to Avoid an Audit

• Don’t wait until you are in ill health• Do what you say you intend to do• Don’t contribute personal-use assets• Keep out enough to meet personal needs• Respect the form of entity (separate books, state and federal filings, etc.)• FLLC is not your personal checkbook• Distribute cash pro rata• Don’t be greedy!

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Pros: Cons:

• Saves substantial estate taxes

• Limits owner liability

• Efficient management

• Keeps business in family

• Makes it easy to transfer fractional interests

• Distributions tax-free to extent of basis

• No real estate excise tax

Case #3Family LLC

• Requires that business formalities are followed (separate books, meetings, reports, tax returns, etc.)

• Cost of set up and administration

• Lender consent may be required

• Some audit risk, if not done correctly

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Case #4Family LLC With Gifting Program

Apartment A, LLC

Harry50%

Sally50%

Children and SpousesUp to $12,000 each per year

Grandchildren’s TrustsUp to $12,000 per year, per beneficiary

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Harry (42.64%)

Sally (42.64%)

Jake and Mary (2.48%)

Jennifer and David (2.48%)

Julie and Mark (2.48%)

Trusts for Grandchildren(7.44%)

Case #4Year 1 Gifts

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Harry (20.46%)

Sally (20.46%)

Jake and Mary (9.92%)

Jennifer and David (9.92%)

Julie and Mark (9.92%)

Trusts for Grandchildren(19.84%)

Case #4Year 4 Gifts

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More Pros: More Cons:

• Further tax savings (gift tax exclusions and discounts)

• Allows heirs to begin participation in business

• Avoids complications of co-tenancy

• Spendthrift protection

• Provides a mechanism for pooling investment assets

Case #4Family LLC With Gifting Program

• Cost of appraisal

• Pro rata distributions can impact cash flow

• Some audit risk, if not done correctly

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Case #5Grantor Retained Annuity Trust (GRAT)

Apartment B, LLC

Harry50%

Sally50%

Value:$1,950,000

GRAT10 Years

$195,000 / yrTo H & S

Gift tax exemption used:$1,070,000

Value: $ 3,570,000

Jake33%

Jennifer33% Julie

33%

Apartment B, LLC

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Pros: Cons:

• Retains identifiable cash flow

• Transfers significant appreciation to heirs

• Saves substantial taxes

• No audit risk, if you comply with statute

• Requires that Grantors survive the term of the trust

• Requires current use of Gift Tax exemption

• Does not facilitate transfers to grandchildren (GST exempt transfers)

• Requires trust administration

Case #5Grantor Retained Annuity Trust (GRAT)

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Case #6Intentionally Defective Income Trust

Apartment C, LLC

Harry50%

Sally50%

Note to H & S $110,000 / yr

Apartment C, LLC

Jake33%

Jennifer33%

Julie33%

IDITSale

60%

• Harry and Sally retain 40% LLC interests• Harry and Sally contribute $117,000 in “seed money”• Harry and Sally take back a 15-year fully amortizing note

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Pros: Cons:• Retains identifiable cash

flow

• Saves substantial taxes

• Does not require current use of Gift Tax exemption

• Transfers significant appreciation to heirs

• Facilitates transfers to grandchildren (GST exempt transfers)

• Does not require Grantors to survive term

• Requires trust administration for term of note

• Limited audit risk, if properly valued and documented

Case #6Intentionally Defective Income Trust

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Questions?

Schwabe, Williamson & Wyatt’s

Real Estate and Business Seminar Series

Thank you.

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About the Presenters

Dennis A. Ostgard is a 1978 graduate of Harvard Law School, and leader of Schwabe, Williamson & Wyatt’s real estate and business practices in the Seattle office. His practice emphasizes commercial real estate transactions, leasing and development projects, business sales and acquisitions, and business entity selection.

Susan L. Peterson is a 1987 graduate of Harvard Law School, who focuses her practice in the areas of real estate, business transactions, and business entity formation, including commercial real estate transactions, business sales and acquisitions, business entity selection, and estate and succession planning for business owners.