Final Planning Steps for Terminally Ill Client

Take-Away: When an individual nears the end of his or her life, some steps can be taken to mitigate future tax liabilities. While during the time they have remaining there are no doubt far more important things to take care of by the terminally ill individual and his/her family, advisors can provide  helpful advice to get their final affairs in order.

Background: A recent article in Trusts & Estates by David Handler and Kristen Curatolo provided some important tips on the last-minute steps an individual who faces imminent death can take to save taxes, crass as that sounds. Those tips are summarized below:

1. FLP and LLC Interests: If an individual owns an interest in a family, limited partnership (FLP) of family limited liability company (FLLC) attention needs to be given to the underlying FLP or FLLC operating agreements. This attention is required because of the recent decision Powell v Commissioner, 148 Tax Court No. 18 (2017), which applied IRC 2036(a) (2) to include the value of the all of the entity’s assets in the transferor-decedent’s taxable estate. The transferor (parent) formed the FLP and transferred general and limited partnership interests to children (or trusts for their benefit.) The transferor only held a limited partnership interest at her death. Under the partnership agreement, the transferor-limited partner, along with other partners, could vote to liquidate the limited partnership. The Tax Court held that the transferor’s ability as a limited partner, acting in conjunction with the FLP’s other partners, to dissolve the FLP was a right to “designate the persons who shall possess or enjoy the cash and securities transferred to the FLP or the income from the entity,” within the meaning of IRC 2036(a) (2). Consequently,  that ability, albeit unexercised, to participate in decision whether to liquidate the limited partnership, resulting in as to who might enjoy the income from the partnership, was sufficient to cause estate inclusion, even though the transferor was only a limited partner and that voting right was never exercised.

Comment: All FLP and FLLC agreements should be reviewed, and if need be amended, to remove any IRC 2036(a)(2) ‘taint’ of retained control by the transferor, such as eliminating voting or liquidation rights retained by the transferor. Alternatively, consider advising the transferor to sell his/her retained interest in a bona fide sale to eliminate any IRC 2036 ties whatsoever.

Note: If the transferor is not expected to survive the removal of these retained rights for 3 years, the gratuitous release of the interests in the FLP or FLLC will still be included in the transferor’s taxable estate under IRC 2035(a). However, a sale of the interests will work to avoid the ‘transfer in contemplation of death’ inclusion rule since that rule provides that IRC 2035(a) will not apply to any “bona fide sale for an adequate and full consideration in money or money’s worth.” [IRC 2035(d).]

2. Grantor Retained Annuity Trusts: If there is a good chance that the grantor will not survive the GRAT’s annuity term, the grantor’s death will cause the value of all of the GRAT’s assets to be included in the grantor’s taxable estate.

Comment: Consider having the grantor’s spouse purchase the remainder interest in the GRAT. If the grantor dies, the value of the annuity will be included in the grantor’s taxable estate, along with the value of the GRAT’s remainder interest. If the grantor’s spouse purchases the GRAT’s remainder interest, the amount that is paid by the spouse to the GRAT’s remainder beneficiaries will be removed from the spouse’s estate, without any gift tax so long as adequate consideration is paid for the remainder interest. In effect, the spouse’s purchase of the remainder interest has the effect if the GRAT successfully continued to its termination- a shift of wealth to younger generation family members at no gift-tax cost.

Note: If a sale of the GRAT’s remainder interest is contemplated, the GRAT’s remainder beneficiary should be an existing irrevocable trust. A single party could negotiate the terms of sale of the GRAT’s remainder interest. In addition, if that trust is a grantor trust, there will be no capital gains recognized on the purchase of the remainder interest.

3. Preserve Tax Losses: If the individual owns depreciated assets, i.e. the fair market value is less than the income tax basis of the asset, that built-in loss will be extinguished on the owner’s death; the income tax basis will be stepped-down.

Comment: To avoid never being able to use the tax loss, the owner might consider: (i) selling the depreciated asset before death, thus recognizing the loss to offset capital gains; (ii) gift the depreciated asset to the owner’s spouse; or (iii) sell the asset to a grantor trust or a non-grantor trust. As a rule, when property is acquired by gift, the donee takes the property with a carryover income tax basis, which is the same basis the donor had in the gifted asset. If the income tax basis is greater than the asset’s fair market value at the time of the gift, the basis is the property’s fair market value for purposes of determining the tax loss. Restated, the tax loss cannot be gifted. [IRC 1015.] IRC 1015 is based on whether a gift has occurred; it is not based on whether there is a new owner for income tax purposes.

Note: The gift of the depreciated asset to a spouse will carry-over the donor’s income tax basis in all events, including the determination of loss. [IRC 1015(e) and IRC 1041(b) (2).] If the depreciated asset is sold to a grantor trust IRC 1015 does not apply, since it is a sale and not a gift, thus preserving the loss of future use. Even if the depreciated asset is sold to a non-grantor trust, the loss will not be realized. This is caused by the related-party rules, again, preserving the loss for later use, since the selling owner is disallowed the realization of the tax loss. [IRC 267(b) (4).]

4. Direct the Sale of Unwanted Property: Many assets that an individual owns will be sold after the owner’s death because their heirs do not want the asset, and would rather have the cash the item represents. Examples would include heirlooms, antiques, artwork or other collectibles that were important to the owner, but not his/her heirs. The owner might identify which of these items are desired by family members, and which items are more likely to be sold after the owner’s death.

Comment: If the asset’s value is more important to the owner’s heirs than the asset itself, then the owner’s Will or trust should be amended to direct the sale of that asset with the addition of the sales proceeds to the residue of the probate estate or the trust. The inclusion of this direction in the testamentary instrument will allow for a deduction for the costs, fees and expenses that are associated with such sale for estate tax purposes.

5. Accelerate Charitable Bequests: Many estates include charitable gifts. However, with the temporarily large federal estate tax credit, there is less of a need to rely upon the charitable deduction to avoid federal estate taxes, meaning that the charitable bequest in a Will or Trust will not save any estate tax.

Comment: If the same charitable transfer occurred during the donor’s lifetime, that transfer could effectively be used as a charitable deduction to reduce federal income taxes. This might take the form of a qualified charitable distribution of the owner’s IRA (if over age 70 ½) or the transfer of appreciated assets to the charity, for which a charitable income tax deduction can be claimed.

Note: Accelerating charitable bequests into lifetime gifts in order to use the charitable deduction to offset income tax liability may not be available to many owners who cannot itemize their income tax deductions due to the ‘doubled’ standard exemption amount. However, if the size of the ‘accelerated’ charitable bequest is large enough, that lifetime charitable gift might justify itemizing income taxes in the year of the charitable gift.

Conclusion: There are a lot more important things to address than saving taxes when an individual is terminally ill and their life is coming to an end. However, many of those terminally ill individuals worry about providing for their family after they are gone. If they understand that there are some steps that can be taken while they are still alive to help reduce the tax burdens their family members will face once they are gone, those individuals will probably be receptive to some of these strategies.

Final Note: The authors of the article just summarized have compiled a 30-Point Checklist in “Planning for the Eleventh Hour.” I will share that with you in a separate summary.