level iii - estate tax principals and structuring options ... · wealthadvisory | outsourcing |...

11/28/2016

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WEALTH ADVISORY | OUTSOURCING | AUDIT, TAX, AND CONSULTING

Investment advisory services are offered through CliftonLarsonAllen Wealth Advisors, LLC, an SEC‐registered investment advisor. | ©2016 CliftonLarsonAllen LLP

Estate Tax Principles and Structuring Options for Successful Family Business TransitionsPaul Neiffer, CPA

November 16, 2016

©2016 CliftonLarsonAllen LLP


About CliftonLarsonAllen

• A professional services firm with three distinct business lines

– Wealth Advisory

– Outsourcing

– Audit, Tax, and Consulting

• 4,500 employees

• Offices coast to coast

Investment advisory services are offered through CliftonLarsonAllen Wealth Advisors, LLC.

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Agribusiness

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Speaker Introduction

Paul Neiffer, Principal, CliftonLarsonAllen – Frequent national speaker on taxation, agricultural, farm

bill and estate tax topics

– Current chair of the AICPA National Agriculture Conference committee.

– Past President of Farm Financial Standards Council

– Author of the “FarmCPA” Top Producer column

– Primary source for nationally recognized blog “FarmCPAToday.com”

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WEALTH ADVISORY | OUTSOURCING | AUDIT, TAX, AND CONSULTING 5


WEALTH ADVISORY | OUTSOURCING | AUDIT, TAX, AND CONSULTING 6

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BUT FIRST‐An Income Tax Quiz

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When Did the Income Tax Get Added to the Constitution?

1. 1897

2. 1904

3. 1913

4. 1921

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Answer

• 1913 – the 16th Amendment was passed on February 3, 1913

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Which Country Has the Highest Corporate Tax Rate

1. United States

2. Japan

3. United Arab Emirates

4. France

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Answer

• United Arab Emirates at 55% – But the US is in second place at 38.92% including state income taxes.

• The Worldwide average is 22.5%.

• Europe has the lowest average rate at 18.88%

• It has declined from 30% to 22.5% since 2003

• To get the lowest rate you need to move to Uzbekistan at 7.5%

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What Was the Highest Income Rate in US History

1. 73%

2. 94%

3. 88%

4. 81%

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Answer

• 94% in 1944‐1945 to fund World War II.

• They were kind and dropped it to 91% in 1946

• 70% in 1981

• President Reagan lowered the rate to 50% between 1982 and 1986

• Bounced around between 35% and 39.6% since 1987

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Tax Strategies forFamily Business Transitions



Family Farm Transitions Agenda• Understanding Estate & Gift taxes

• Structures for farmland transitions:

– Part gift/part sale on direct land transfers

– Use of entity for land: Farm successor

– Use of entity for land: No heirs

• Structures for operating entities

– No heir

– On farm heirs

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LET’S TALK TAXES• Upon death, up to $5.49 million (as of 1/1/2017) will pass exempt from Federal Estate Tax. A married couple can pass $10.98 million.

• During lifetime, you may give away up to $5.49M of your assets exempt from Federal Gift Tax, which would reduce the amount of your exemption remaining at death.

• For estates or gifts in excess of this exemption, the maximum tax rate is 40%.

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LET’S TALK TAXES, continued• Portability Election of unused exemption to surviving

spouse. Can be a $5.49M mistake if not timely elected!

• $14,000 annually to as many individuals as donor wishes, without reducing door’s $5.45M estate tax exemption or triggering Gift Tax.

• State inheritance or estate taxes deserve special attention: Connecticut, Delaware, District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oregon, Rhode Island, Vermont, Washington, Iowa, Kentucky, Nebraska, Pennsylvania

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Special Use Valuation

• Estate Tax Special Use Valuation (Sec. 2032A)– ≥ 50% of estate consists of farming assets– Actively farmed prior to death or retirement– An heir continues to actively farm ≥ 10 yrs. post‐death

• Value land at lower 5‐year. average capitalized rent value– Valuation reduction limited to approx. $1.1M– IRS will file lien and heirs must farm properly for next 10 years

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Special Use Valuation Example

Fair market value of land (per acre) $8,500

Average cash rents for comparable land $200

Current real estate taxes $10

Net cash rents $190

Farm Credit System current interest rate 5.50%

Special use value $3,455

Approximate maximum reduction in value $1.1 Million

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Transitioning the Land

• Gift

• Sale

– Outright

– Seller‐financed (installment sale)

• Combination gift‐sale

[Same choices, whether transferring acres or entity shares]

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Part gift/part sale –Strategy for one heir

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Part Gift – Part Sale Strategy

Example

• Low basis (i.e., tax cost) in land

• Objective: Sell to a family member at a price that can be paid in an installment sale using annual cash rents

• Bargain element (full FMV less sale price) = gift

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Example Per acre

• Full appraised FMV $9,500

$4,500 gift

• Sale price (to family) $5,000

$4,000 cap. gain

• Tax basis (cost) $1,000

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Planning tips

• Importance of a qualified appraisal to prevent IRS attack on amount of gift

• Opportunity: Lock in low interest rate on installment note to family member

– Based on IRS AFR% for month of sale

– November 2016 rate: Over 9 yr. term: 2.07%

– October 2015 rate: Over 3 yr. & ≤ 9yr.: 1.33%

• President Trump may cause interest rates to increase

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Use of a Limited Liability Entity to Transfer Farm Land

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Use of entity for transfer of land –with farming successor



Example 1: Farming Successor

Facts:• Dad and Mom ages 75 and 73; 1,400 acres of land

• Net worth about $13.5M ($12M land + $1.5M investments)

• 3 adult children, all married with children

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Example 1: Farming Successor (cont.)

Facts:

• Active farm assets (inventory & machinery) owned by Jr.

• Dad and Mom are retired landlords

• Land is cash-leased to Jr.

• Objectives: Hold land together and assure Jr. has access to lease and buy land

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Example 1: Limited Liability Entity

H W Jr. C‐2 C‐3 Jr.

97% 1% 1% 1%

LLE(Land)

$ Rent FarmingEntity

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Additional LLE document issues if tenant-successor:• Define Jr. as having first right to lease and define

terms – Example: 95% of county extension average lease rates

• Define right of Jr. to purchase land parcels from partnership (e.g., appraisal mechanism; seller-financed terms)– Don’t give him 1st right of refusal

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Additional LLE document issues if tenant-successor:• Consider specific designation of voting units

– Example: 3 voting units: Dad, Mom and Jr. – At second parent’s death, 1 unit to Jr. & 1 to non-farm

child– Jr. has control (2 of 3 votes), but one child to monitor

compliance with LLE document


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Limited Liability Entity

Avoiding family conflict:

• Thorough communication at formation about Dad & Mom’s objectives

• Emotional and financial buy-in by each child

• Consider use of consultant to sort out conflicting objectives of children/misconceptions/hidden heartburn– Private interviews; feedback to Dad & Mom

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Use of entity for transfer of land –with no farming successor

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Case Study : No Farming Successor

Facts:

• Same dollar facts as previous example

• 3 adult children, all married, none farming

• Land has been cash rented to unrelated tenant

• Objectives: Hold land together for children/ grandchildren

– Concerned about spendthrift lifestyle of Child 3

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Limited Liability Entity (LLE) Illustration

H W C‐1 C‐2 C‐3

LLE

Gifts

Land35



Case Study: Limited Liability Entity

H W C‐1 C‐2 C‐3

LLE(Land)

$ Rent

Cash distributions out of LLE allocated 70‐10‐10‐10

70% 10% 10% 10%

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LLE Advantages

• Facilitates gifts

– Annual exclusion of $14,000

– Discounts for minority and lack of marketability

• Most units non‐voting (to allow management control to selected partners)

– Centralized management

• Terms for buy‐out of a member

– Discount if early exit (e.g. 80%‐90% of appraised value)

– Specify pmt. terms (long term /low interest rate to preserve entity cash flow)

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LLE Advantages

• Include binding mediation/arbitration language if disputes arise

• Design of LLE document forces family communication pre‐death

– Require each child to invest cash at formation to force legal and emotional buy‐in to the operating agreement

• Require super‐majority to liquidate the partnership/distribute land

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LLE Disadvantages

• Fees

– Legal costs of document drafting/planning

– Appraisal fee for land valuation

– Appraisal fee for discount valuation

• IRS valuation disputes

• Annual partnership tax return

– Separate checking account

• Proper allocations of any cash distributions each year

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Structure for operating entities – no successor



Disposition of Operating AssetsOrdinary Installment SE

or Cap. Gain? Method? Tax?• Grain Ordinary Yes Yes• Livestock: Resale Ordinary Yes Yes• Livestock: Breeding‐

raised Cap. Gain Yes No• Depr. machinery/

breeding stock Ordinary No No• Bins, barns, tiling,

irrig. Ordinary No No• Land Cap. Gain Yes No

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Disposition of Raised Grain or livestock: No Successor

• Spread sales over several tax years

– Multiple yrs. of lower tier Soc. Sec. tax (15.3% on first $127,200 as of January 1, 2017)

– Miss high grain prices by holding crop?

• Sell early at high price and take installment payments

– Credit risk?

– Same Soc. Sec. tax cost

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The Use of Charitable Trusts for Exiting Farmers



Charitable Remainder Trusts (CRT)

Donor

Char.Rmdr.Trust

CharityAsset

Term

Income

Rmdr.

After Term

(No TaxOn AssetSale)

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Charitable Remainder Trusts

• ANNUITY TRUST

– Fixed payout

– No additional funding

• UNITRUST

– Payout is % of annual value

– Additional assets can be contributed

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CRT for Farmers

• Funding a CRT with ordinary farm assets (PLR 9413020)

– No income or SE tax to proprietor for inventory or fully depreciated equipment (other than potential Section 179 recapture)

– Expenses allowable for current year crop

– CRT sells inventory tax‐free

– Distributions from CRT = ord. income but not SE income

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CRT Anti‐Abuse Rules

• 10% charitable remainder minimum

• 50% maximum payout

• 5% probability of exhaustion

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10% Charitable Remainder Minimum

• At time of set up, the amount of residual expected to pass through to the charity must be calculated to be at least 10% of the current contribution

• The actual amount does not need to be 10%, but the expected amount based on terms of trust must be at least this %

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50% Maximum Payout

• The maximum annual payout percentage cannot be greater than 50% of the initial fair market value of the trust in the case of a CRAT and 50% of the net fair market value of a CRUT on an annual basis.

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5% Probability of Exhaustion

• In 1977, IRS indicate no deduction if there is more than 5% chance the trust would be exhausted.

• This is not applicable to a CRUT with a net income limit (NIMCRUT) since under this formula the trust corpus is never invaded

• As a practical matter, with today’s low interest rates, CRATs based on a donor life expectancy will fail the 5% rule even though they pass the 10% rule.

• IRS just released guidance easing the impact of this rule

• Software is used to determine whether the structure will meet all three tests.

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CRT Design Issues

• Select the highest of the 3 AFRs to maximize the income payout

• Use a fixed term CRAT to reduce income tax exposure in early years

• Analyze other factors

– Social security

– NIIT

– MRD, etc.

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CRT Illustrations

• 1.4% AFR

• 10 yr. term, annual payout at year‐end

• $750,000 funding

• Payout amount ‐ $72,800

• Charitable Remainder – 10%

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Illustration – Section 1245 Gain (Equipment)

• After‐tax accumulation after 10 years:

– Outright sale $460,238

– 10 Yr. CRAT $504,151

– 10 Yr. CRUT $504,190

• Savings using CRT – About $44,000 plus $75,000 to charity

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Illustration – Grain Inventory (SE)

• After‐tax accumulation after 10 years:

– Outright sale $413,869

– 10 Yr. CRAT $504,151

– 10 Yr. CRUT $504,190

• Savings using CRT – About $90,000 plus $75,000 to charity

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CRT Cautions

• Section 179 recapture applies

– Identify appropriate assets

• Need appraisal if transfer “unmarketable securities”

• No active business interests: UBI tax

• No debt into CRT

• No self‐dealing (CRT sells assets in open market, not to related party of donor. No loans to donor or related party)

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CRT Compliance

• Form 5227, Split‐Interest Trust Information Returns

– Schedule K‐1 (Form 1041) to beneficiary

– Copy of CRT document in 1st year filing.

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Pairing of ILIT with CRT

• Many farmers will use tax savings of CRT to fund an Irrevocable Life Insurance Trust (ILIT):

– Provide liquidity to estate

– Vehicle to pass on assets to off‐farm heirs

– Increase the amount of assets on an estate tax free basis.

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The Use of Cash Balance Plans to Offset Deferred Tax Liabilities

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Strategy

• Depreciable purchases

• Prepaid expenses

• Deferred grain sales

The Negatives

• Bonus and large Sec. 179 ending

• Diminished need for more equip.

• Already maximized

• Credit risk

• Only several year deferral

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Traditional Approaches: Farm Income Deferral



Cash Balance Retirement Plan Solution

• Age‐based funding ($100K ‐ $200K input per year)

– 5 year funding commitment

– Low overhead arrangement for defined benefit features

• Long term deferral of income (2 generations)

• Creditor protection

• Source of liquidity to off‐farm heirs?

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Cash Balance Plan Illustrations

Age‐based Impact

• Assume 2017 earned income of $255,000

Age 2017 Deduction60 $229,50050 $140,25040 $ 89,250

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Components of the Funding

• Age 62, $250,000 earned income

• 401(k) with profit sharing plus cash balance plan

Plan Component Funding and Deduction

Employee deferral $ 23,000

Employer safe harbor 7,500

Employer profit sharing 5,000

Employer cash balance 237,500

Total Funding/Deduction $273,000

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Cash Balance Plan Illustrations



Employee Coverage

• Can exclude family employees

• Unrelated employees: 1,000 hour test

• May use 3 year cliff vesting – Counted from first day of the plan

• May blend ages of employee group– A 60 yr. old can be blended with 20 yr. old and 30 yr. old employees

• Typical employee funding of 8%‐12% – Legal minimum: 7.5%

– One older employee: 16‐20%

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Actuarial and Administration

• Set‐up fees run about $1,500 to $3,500

• Annual services can be in the same range depending on number of employees and complexity of plan

• Includes plan documents, amendments, compliance testing, IRS Form 5500, actuarial analysis

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DEALING WITH LAND TRAPPED IN A C CORPORATION

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C Corp. with Land Inside: No Successor• Liquidate grain/livestock inventory and M&E as a C corp.

– Use C corp. lower tax rates

– Possible offsetting deductions for past underpaid services to employee‐shareholders?

• Convert to S corporate status after disposition of all operating assets

– S corp. holds land only; becomes landlord entity

– Net rent income flows through to corp. owners

– But S corp. must be “active” (crop share rents) or pay out its prior C corp. earnings as a dividend

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C Corp. with Land Inside: No Successor

• After death of owner, stock gets step‐up in basis

• Heirs sell land

– Creates additional gain to add to stock basis

• Heirs then liquidate in year of sale

• Result equals no capital gains tax due (or even a small loss)

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USE OF CORPORATE ENTITY TO TRANSITION OPERATING ASSETS TO NEXT GENERATION

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Forming a Farm Corporation

• Clean cut-off: End all farm income and expense activity of farm proprietorship checking account; start corporate checking account activity next day

• Prepare bill of sale to transfer to corporation

– Unsold inventory (grain, livestock)

– Accounts receivable (sold, but deferred pmt.)

– Other assets (breeding stock, M&E)

– Never land!

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Case Study: Active Operations to Successor

Facts:

• Dad, age 65, operates as Schedule F proprietor

– Owns grain, machinery, and land

– Objectives: Retire in several years, liquidate grain, and sell machinery to son

– Est. grain value: $800,000; machinery $500,000

• Jr., age 34, farms with dad, but also files as proprietor

– Owns his share of grain, some machinery (total value $200K)

– Buying 160 acres on contract from grandmother

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Plan A: Liquidate grain/lease & sell machinery to Jr.

Federal tax Income Tax Soc. Sec. Tax

Asset (35% blended) (9% blended) Total

$800K grain $280K $72K $352K$500K machinery $175K $ ‐ $175K$1.3M $455K $72K $527K

41% Combined Tax

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Plan B: Use an Entity to Transition Operating Assets

Sr. Jr.

87% stock

13% stock

S Corp.

Grain & machinery

$1.3M

Grain & machinery

$200K

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Sr. Jr.NOTE

STOCK

87% 13%

S Corp.

$1.5M grain & machinery

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Strategies with corporate entity:

• Capital gain & no SE tax to Sr. on stock sale

– Cuts effective tax rate from 40% to 20%

– Spread gain over term of note (e.g., 10 yrs.)

• Sell stock in minority increments with discounts

• Consider reorganizing into voting & non‐voting shares

– Sr. can dispose of most stock, but retain control if desired

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Sr. Jr.$

Note Pmt.

10% 90%

S Corp.

$90% of cash distributions

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Plan A Sale Plan B (Entity)

Value of grain/machinery $1,300K $1,300K

Less stock discount (25%) (300K)

Less tax cost: A @ 40% (520K)

B @ 20% (200K)

Net to Sr. after taxes $780K $800K

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Case Study: Summary

• Entity sells Sr.’s grain, but offsets income with ongoing farm input expenses & prepaids

• Jr. does not get fresh depreciation on machinery

– Bought nondeductible stock, but at a discount

– Jr. gets favorable long‐term financing from Sr.

– Jr. has cash method farm expenses to continue tax deferral

• S corp. distinguishes salaries vs. rent vs. owner distributions

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AUDIENCE PARTICIPATIONCASE STUDY

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FACTS

• Jack, age 68, Jill age 65 currently own 1,200 acres worth $12 million

• They own equipment worth about $1.5 million with little or no tax basis

• They have about $1 million of carryover grain with no tax basis

• They have life insurance on each other with a face value of $2 million each

• They have 4 children, Sam farms with dad but has his own operation

• The other three children live out of state

• Jack would like to retire around age 75 since his health is good

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OBJECTIVES

• Wants to minimize the tax costs of transferring/disposing of the grain and machinery when Jack finally retires

• Wants to make sure that Sam can farm the ground and has the right to purchase the ground after they pass away

• Wants to maintain harmony in the family

• Wants to eliminate the estate tax if possible

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QUESTIONS

• What entity would you use for the transfer of the equipment to Sam?

• How would you dispose of the excess grain?

• What would you do with the life insurance?

• How would you structure the farm land holdings?

• Other questions that arise?

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Thank You

• Thanks for Attending

• Questions

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Paul Neiffer, CPA509‐823‐2920 (direct)509‐961‐9739 (cell)[email protected]: www.farmcpatoday.com

level iii - estate tax principals and structuring options ... · wealthadvisory | outsourcing |...

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