FORESIGHT

"The whole is worth more than the sum of its parts."

To illustrate, suppose you have a crisp, new, $100 bill. You hold it in your hands and tear it into two pieces of equal size. You then give one half to a friend. What is the value of what you have given to your friend? It is one "half" of a $100 bill, but it is hardly worth $50. He won't have much success if he tries to spend it at the corner store. He can realize its true value only if he cooperates with you. He may find someone who is willing to pay him something for it; someone who sees the prospect of working together with you to reconstruct the bill. But on the open market, the value of your friend's half is only a small fraction of $50. The same can be said of your piece. By ripping the bill in two, you have created two pieces whose value, when combined, is far less than the piece of currency you started with.

Normally, it is foolish to "destroy" value in this way. But in the topsy-turvy world of estate and gift tax planning, a lower value means less tax when assets are transferred to children or other beneficiaries. That makes sense - if the full value can ultimately be realized by the beneficiaries.

A family holding company (FHC) is a legal entity, such as a corporation or a partnership, that is formed for the purpose of owning valuable assets. When first formed, it is often owned entirely by the senior generation of a family. Over time, partial interests in the company may be transferred to younger family members. A "piece" of a family company transferred in this manner is somewhat like a fragment of a $100 bill. Its value is low - far less than its proportionate share of the company's worth. This is referred to as a "valuation discount." Through a series of lifetime gifts and transfers at death, the entire holding company is passed to the younger generation or generations. The transmission of the company in "pieces", over time, produces far less estate and gift tax than would result from a transfer of the entire entity at once.

There's more to life than taxes

Estate and gift tax savings are the primary reason for the pervasive interest in family holding companies today. But tax planning is not the only reason to use a holding company. The FHC permits a family to share ownership of assets without many of the worries that normally accompany shared ownership. Management can be centralized, avoiding disputes and deadlocks over major decisions. The interests of younger generation members can be insulated from the claims of creditors, so the family's wealth is not put at risk. An interest in a family holding company can be structured so that it will not be lost to the spouse of a family member if there is a divorce. An FHC can also avoid the need for a separate probate proceeding for real estate located in a distant state.

An example

Mom and Dad have substantial real estate holdings. Even though they have incorporated estate tax planning into their wills, their estates will be subject to estate tax at a marginal rate of 55 percent. They would like their adult children to get involved in ownership and management of the properties. But they are not yet ready to give up control.

Mom and Dad form a limited partnership and transfer the real estate to the partnership. At the beginning, they are the only partners. They each have two different kinds of partnership interests: general and limited. A limited partner shares in the financial fruits of the partnership business, but does not participate in decisions regarding management. General partners also share in profits and losses, to the extent of their percentage interests. But more importantly, general partners manage the day-to-day affairs of the partnership and make major decisions.

Mom and Dad begin transferring limited partnership interests to the children. The value of these gifts for tax purposes is small, and they are sheltered from gift tax by the annual exclusion of $10,000 per year. Meanwhile, Mom and Dad as general partners control the operation of the company. Over time, the children acquire significant interests as limited partners. If and when the parents are ready to share control, they can convey general partner interests to one or more of the children. Any interests not given away during lifetime will be transferred to the children by will.

For gift tax purposes, each of the interests given to a child is entitled to a valuation discount. If Mom and Dad still own partnership shares at their deaths, those interests may also be discounted. The end result is the transfer of all of the real estate to the children. But the sum total of all of the transfers is far less than the value of the real estate itself. By forming a family holding company and using it to transfer the real estate in installments, Mom and Dad have dramatically lessened their estate tax.

What does the IRS say?

The Internal Revenue Service agrees that a valuation discount is allowable for an interest in a family holding company. It's not because the IRS has suddenly become overcome with generosity. Rather, the courts have consistently required that IRS recognize and apply these discounts. A recent example is the case of the Estate of Lucile M. McCormick, decided by the United States Tax Court on August 7, 1995. Mrs. McCormick and her husband were partners in two family real estate partnerships. Between 1986 and 1988, they gave small interests in the partnerships to various family members. After Mrs. McCormick's death, the Tax Court was called upon to resolve a dispute over the value of the partnership interests given away and those owned by Mrs. McCormick at the time of her death. The Court found that the McCormicks were entitled to claim discounts to reflect the minority nature of the interests and for lack of marketability. The Court allowed combined discounts ranging from 38 percent to 54 percent.

In other words, the amount subject to tax was decreased by 38 percent to 54 percent through the use of the holding company.

Details

There are many different ways to structure a family holding company. The company may be a corporation, a partnership, or a limited liability company (LLC). Or a combination of entities may be used: for example, a limited partnership with a corporation or an LLC as the general partner. Sometimes, a holding company is combined with a trust to increase the tax benefits. In most cases, the transfer of an interest in the company is restricted. This prevents persons outside the family from becoming part owners.

To establish the value of an interest given away, you must obtain an appraisal report. Often two appraisals are required. In the example described above, Mom and Dad will get a report of the land value from a real estate appraiser. In addition, they will obtain a valuation of the partnership interests given away from a professional who specializes in analyzing the financial aspects of businesses. When the legal, appraisal, accounting and other costs are tallied, the total can be substantial. But the tax savings can make the expenditure worthwhile. Typically, a family forming a holding company pays costs in the five-figure range, and enjoys tax savings of six or seven digits.

Final thoughts

Not every family needs a holding company. But owners of substantial real estate holdings, valuable securities, or business interests need to be concerned about the tax-related and non-tax aspects of passing the estate to the next generation. Sometimes, a family holding company is part of the answer.

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At this writing, Congress and the President continue negotiations over the balanced budget legislation. The bill as sent to the President includes a gradual increase in the estate and gift tax exemption to $750,000 between 1996 and 2001. Targeted estate tax relief for family -owned businesses is also included.

Subscribers to Foresight will receive a special update issue by e-mail after the legislation is finalized.

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New Jersey has adopted the Uniform Transfer on Death Security Registration Act. This law permits stocks, bonds and brokerage accounts to be made payable to a beneficiary on the death of the primary owner or owners. Registration in beneficiary form is shown by the words "transfer on death" ( abbreviated "TOD") or the words "pay on death" (abbreviated "POD"). A beneficiary designation takes effect only on the death of all primary owners. The beneficiary has no rights during the life of the owner or owners, and the beneficiary designation can be revoked without the consent of the beneficiary.

The law provides that a broker or transfer agent may adopt a statement of "terms and conditions" establishing procedures for registering in TOD form, and governing issues such as the sharing of proceeds among multiple beneficiaries.

Comment: The terms and conditions adopted by the transfer agent or broker may have a significant effect on the operation of the beneficiary designation. They may, for example, govern the result if one of multiple beneficiaries dies before the primary owner. It is suggested that a copy of those terms and conditions be obtained and reviewed before registering securities in this form. TOD registration and other nonprobate transfers should be coordinated with the balance of the estate plan.

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The case of Hill v. Estate of Richards, decided by the New Jersey Supreme Court on December 14, 1995, involved a dispute over the distribution of a trust established by J. Seward Johnson, founder of the Johnson & Johnson corporation, for his daughter, Mary Lea Johnson Richards.

The trust, which was created in 1944, had grown to more than $70 million by 1990. The trust instrument provided that on the death of Mrs. Richards, the trust assets were to be divided according to instructions left in her will. After Mrs. Richards' death in 1990, her surviving husband and her adult children from a prior marriage entered into an agreement interpreting and implementing the instructions left in her will. The agreement provided for a cash distribution of $6.5 million to Mr. Richards, and $100,000 and 800 shares of Johnson & Johnson stock to each of the children. The balance of the trust was to be divided in percentages: 47 percent to Mr. Richards and 53 percent among the children and grandchildren. The agreement also provided that any income received on trust assets after Mrs. Richards' death was to be divided in the same proportions as the balance of the trust (47% to Mr. Richards, 53% to the children and grandchildren).

In September of 1990, at the request of Mr. Richards and the children, the trustee distributed the cash and stock called for in the agreement, retaining the balance for distribution at a future time.

To understand the dispute that developed, some background is required. The federal tax law provides, subject to some exceptions, that when a distribution is made from a trust, it is treated for income tax purposes as a distribution of income earned on trust assets, even if principal, not income, is actually distributed. The beneficiaries are then required to pay tax on the income in proportion to the value of the assets distributed to them during the tax year.

Mr. Richards had received 91% of the 1990 distribution. Thus, he was taxed on 91% of the trust's taxable income of $1.65 million for that year. This was true even though he was entitled under the agreement to only 47% of the trust income. The children were taxed on less than 9% of the 1990 trust income ($150,000), even though they were entitled to 53% (more than $900,000).

Mr. Richards requested an "equitable adjustment" reimbursing him for the $291,000 in tax and interest that he was required to pay on income received by other beneficiaries. The Supreme Court affirmed the decision of the Chancery Division denying such an adjustment. The Court concluded that the disparity in this case had been created by Mr. Richards' decision to request an advance distribution from the trust. According to the Court, "because the beneficiary who received the disproportionate advance distribution drew up the agreement for the interim distribution, he was in the best position to foresee and foreclose the possibility of disproportionate tax treatment of the distributions."

Comment: This case highlights the importance of income tax planning when distributions are made from a trust or estate. The disparity occurred because the initial distribution of cash and stock and the final division of trust assets were made in different years. The issue would not have arisen if the entire distribution were made at one time, or if the preliminary distribution were proportionate to the overall interest of the beneficiaries.

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The case of Coffey v. Coffey, recently decided by the New Jersey Superior Court Appellate Division, is a good example of how not to plan and implement a lifetime trust. In 1973, Thomas Coffey prepared a memorandum stating that he desired to give money to his three young daughters "without it becoming legally theirs when they are 21" and in a manner that would minimize or eliminate the tax impact from transfers to them. There was no trust agreement; Coffey's memorandum was the only written expression of the terms of the trust. In 1978, Coffey began purchasing investments in accordance with the trust plan explained in the memorandum.

In 1988, Coffey and his wife were divorced. They entered into a settlement agreement that required Coffey to pay for the college expenses of the couple's youngest daughter, and required that he maintain the 1973 trust for the benefit of all three daughters.

In the ensuing years, Coffey paid from the trust the expenses of his youngest daughter's college education. His family members objected, arguing that the college expenses must be paid from Coffey's individual funds, and that the trust should be kept intact for ultimate distribution to the children in equal shares.

The court first found it necessary to decide whether there was a trust at all. The court concluded a trust had been created, even though the assets had not been segregated from Coffey's own property. According to the court, "this is an understandable problem when a person attempts to create a trust without proper legal advice and instruction."

The court ruled that Coffey had failed to act properly as trustee. He was not entitled to pay the college expenses from the trust because he was personally liable for those costs under the divorce agreement. Nor was he permitted to use the trust to pay his legal fees for the litigation, as he had done. Finally, the court found that Coffey had improperly attempted to use the trust to control his daughters.

The court removed Coffey as trustee and appointed a receiver to act as substitute trustee.

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At the time of her death in 1988, Clara Hoover owned a 26% interest in a family limited partnership that operated a cattle ranch in New Mexico. In filing the estate tax return, her estate took advantage of two tax breaks available under federal law. One is the special use valuation provision contained in section 2032A of the tax code. Subject to limitations, it permits farmland to be taxed at its value for farming purposes, rather than what it would bring if sold for development. The farmland in the Hoover partnership was worth $10.5 million for development purposes, but only $2 million as farmland.

The second tax break is the valuation discount for Mrs. Hoover's minority interest in the partnership. (For more information on valuation discounts, see the feature article in this issue of Foresight.) The estate claimed a 30% discount for lack of control and marketability. The IRS agreed on the amount of the discount, but objected the combination of the valuation discount and the special use valuation. The U.S. Tax Court, in a 1994 decision, agreed that the minority discount was unavailable because the estate had elected to claim special use value.

The Court of Appeals for the 10th Circuit has reversed the Tax Court decision and held that both tax benefits can be combined. According to the court, "the fact that the decedent owned her interest in the ranch through a limited partnership rather than outright does not change the application of section 2032A." The court concluded that Congress intended special use valuation to apply to interests held indirectly, such as through a partnership. Thus, the Estate was entitled to subtract the $750,000 maximum reduction under section 2032A from the discounted value of the partnership interest.

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A gift to a trust is eligible for the $10,000 annual gift tax exclusion only if the trust beneficiaries can obtain current ownership or use of the assets placed in trust. In order to qualify trust contributions for the annual exclusion, many irrevocable trust agreements give the beneficiaries the right to withdraw assets within a limited time after they are added to the trust. The 1968 court decision in the case of Crummey v. Commissioner approves this technique, and for that reason this type of right to withdraw is often referred to as a "Crummey power." For the power to be effective, the beneficiaries must be entitled to notice of their right to demand assets from the trust.

If contributions to the trust are made annually, giving written notice of each addition to all beneficiaries can be an administrative headache. As a remedy, some trust agreements provide that the beneficiaries may waive their right to future written notice of their withdrawal rights. In Technical Advice Memorandum (TAM) 9532001, the IRS has ruled that the failure of trust beneficiaries to receive actual notice of trust contributions denied the annual exclusion, even though the beneficiaries had waived the right to receive notices, and had the ability to revoke the waiver at any time.

Comment: A TAM is a private ruling, directed only to the taxpayer to whom it is issued, and may not be cited as precedent. Nevertheless, it is a valuable indicator of the Service's position. This ruling suggests that the IRS will challenge the use of a waiver to dispense with the notice requirement. At least as to future contributions, the issue may be avoided by giving notice to the beneficiaries, even if the legal right to such notice has been waived.

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A Qualified Personal Residence Trust (QPRT) is a tax-favored way to transfer ownership of a home to children or other beneficiaries. But it may be used only for a primary or secondary residence, and surrounding land that is "reasonably appropriate for residential purposes." In this ruling, the IRS conceded that a home and the 18-acre lot on which it sits qualify for creation of a QPRT. The house is used by the taxpayer as a vacation home from June through September each year. The surrounding 18 acres consist primarily of swampland and a stream. The house and land were received by the taxpayer from her parents, who purchased the land and built the home in the 1920's. Under these circumstances, the IRS was satisfied that the home and the land were a single residential unit.

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When a married IRA owner dies, the proceeds may be transferred to an IRA in the name of the surviving spouse. Such a rollover is not treated as a distribution, so the income tax deferral continues until funds are withdrawn. This special treatment is generally not available if the proceeds pass to the surviving spouse through a third party, such as an estate.

In this case, Husband's estate was named as the beneficiary of his IRA. Under the terms of his will, some cash bequests were payable to relatives and a charity, and the remainder of the estate passed to Wife, some outright and some in trust. Wife was named as executrix of the estate. Wife proposed to bypass the estate and have the proceeds distributed directly to an IRA in her name.

The IRS ruled that the proposed transfer would qualify as a rollover, and would not be taxable to Wife.

Comment: This ruling is addressed to one specific taxpayer, and should not be relied on by others. Making an IRA payable to your estate is seldom the best choice. Unfortunately, your estate may end up as beneficiary inadvertently, without any action on your part. That's because many IRA plans provide that proceeds are payable to the estate of the participant if no valid beneficiary designation is on file. It is wise to review beneficiary designations periodically, to be sure that they are up to date and won't cause unnecessary tax for your heirs.

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The "timely mailing" rule applies to the filing of income tax returns. Under this rule, the return is filed on time if it is mailed by the due date, even if it is delivered to the IRS afterwards. Two recent cases interpret this rule.

In connection with a bankruptcy proceeding, Frederic Grable sought to prove that his tax returns had been filed on time. He testified that he personally delivered the returns in question to the post office before the filing deadline. The court ruled that this testimony was not sufficient. Under the applicable regulation, proof of postmark - not just proof of mailing - is required. Grable could not prove the returns were postmarked before the due date.

A private postmark can sometimes satisfy the "timely mailing" rule. Because the date on a private postage meter can be changed, the tax regulations say that a private postmark proves mailing only if the mail is received by the addressee within the normal delivery time. The private postmark date on Peter Little's Tax Court petition was one day before the filing deadline. But it was not delivered to the Tax Court until 9 days after the deadline. The normal delivery period for mail from New York City to Washington, D.C. is 3 days. Thus, the Tax Court held that the filing was not timely.

Comment: One sure-fire way to prove timely mailing is by using certified or registered mail. If certified mail is used, the sender's receipt bearing the postmark date should be kept with a copy of the return.

Resist the temptation to use a private carrier like Federal Express or UPS. The courts have consistently held that the timely mailing rule applies only to mail sent via the U.S. Postal Service.

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Stanley Whitten was selected as a contestant on "Wheel of Fortune." In February, 1991 he and his family flew from Chicago to Los Angeles for the taping of the show. On his tax return for the year, Whitten reported his $14,850 winnings, reduced by $1,820 in expenses incurred for travel, hotel and meals.

The Tax Court has held the expenses are not deductible as gambling losses, nor as business expenses. They were either nondeductible personal expenses or, at best, miscellaneous itemized deductions.

Comment: Under Internal Revenue Code Section 67, miscellaneous itemized deductions are allowable only to the extent they exceed 2% of adjusted gross income for the year.

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Profits from illegal activity are subject to income tax. Robert and Pamela Hawkins had income from the sale of illegal drugs. William L. Patch got his by robbing banks. The courts upheld the IRS's imposition of tax liability in both cases.

More interesting is the case of William Irvin, who was entitled to a payment of $183.69 on his discharge from the Army. The government mistakenly issued him a Treasury check for $836,939.19. He used the funds to pay off the mortgage on his father's home, to buy Jeeps for himself and his wife, for home renovations, charitable contributions, and gifts to relatives. Irvin spent over $340,000 of the proceeds of the check before the government discovered its error.

At his trial for illegal conversion of government property, Irvin testified that a short time before receiving the check he had gone to a lonely road and prayed that he would become self sufficient and be able to take care of others. He claimed that he thought the check was a miraculous answer to his prayers, not a government mistake.

Irvin's convictions for conversion and for failing to report the funds as income were affirmed.

Comment: Foresight's first "creative excuse" award goes to Mr. Irvin. For other entertaining excuses, visit the

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A man was walking along a beach one day when he found a magic lamp. He rubbed the lamp, and sure enough, a genie came out and offered him one wish. After thinking for a moment, the man said, "My brother and I had a terrible argument many years ago, and we haven't spoken since. My one wish is that he would forgive me."

The genie was surprised at how noble the man's wish was. "Most people," he said, "wish for power, fame, or prestige. But your wish is totally unselfish. You're not, by any chance, about to die, are you?"

"No," the man replied.

"But my brother is - and he's worth about $60 million."

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FORESIGHT is a publication of De Maio & De Maio, Attorneys at Law. It is not intended as and does not constitute legal advice, nor does it create an attorney-client relationship. The information contained in this publication should not be acted upon without first obtaining the advice of a professional advisor.

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