Schwabe, Williamson & Wyatt’s Real Estate and Business Seminar Series Tax Saving Strategies for Apartment Building Owners March 8, 2006 Seattle, WA
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.
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
Overview of Current Tax Regime Federal Estate Tax
Overview of Current Tax Regime Federal Gift Tax
Overview of Current Tax Regime Washington State Estate Tax
Jake Julie Mary David Mark Jennifer Jason Justin Eva Alex Emma Claire Harry and Sally’s Family Tree Harry Sally
Harry Dies Harry’s Share $5 Million Sally’s Share $5 Million Simple Will Sally Dies Sally’s Estate $10 Million Case #1 No Tax Planning (Simple Wills) Harry and Sally’s Estate $10 Million (all subject to taxes)
Harry Dies Harry’s Share $5 Million Sally’s Share $5 Million Fed Credit Shelter $1.5 Mil State Credit Shelter Trust $2 Mil Marital Trust $1.5 Mil Sally Dies 1/3 Jake’s Share 1/3 Jennifer’s Share 1/3 Julie’s Share Case #2 Basic Estate Tax Planning Harry and Sally’s Estate $10 Million
Case #2 Basic Estate Tax Planning 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
Harry 50% Sally 50% Apartment A, LLC Case #3 Family LLC Structure Member and Co-Manager Member and Co-Manager
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”
Sally 50% Harry 50% Apartment A, LLC Apartment A $3 Million Owned by Harry and Sally Jointly Case #3 Family LLC Strategy Discounted Value @ 35% $1,950,000 All three apartments Total: $9 million All three LLCs Total: $5,850,000
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?
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?
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!
Case #3 Family LLC Pros: Cons: • 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 • 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
Children and Spouses Up to $12,000 each per year Grandchildren’s Trusts Up to $12,000 per year, per beneficiary Sally 50% Harry 50% Apartment A, LLC Case #4 Family LLC With Gifting Program
Case #4 Year 1 Gifts
Case #4 Year 4 Gifts
Case #4 Family LLC With Gifting Program More Cons: More Pros: • Cost of appraisal • Pro rata distributions can impact cash flow • Some audit risk, if not done correctly • 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
$195,000 / yr To H & S Jennifer 33% Sally 50% Harry 50% Jake 33% Julie 33% Apartment B, LLC Apartment B, LLC GRAT 10 Years Value: $1,950,000 Value: $ 3,570,000 Case #5 Grantor Retained Annuity Trust (GRAT) Gift tax exemption used: $1,070,000
Case #5 Grantor Retained Annuity Trust (GRAT) 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
Note to H & S $110,000 / yr Sally 50% Harry 50% Jennifer 33% Jake 33% Julie 33% Apartment C, LLC Apartment C, LLC IDIT Sale 60% Case #6 Intentionally Defective Income Trust • 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
Case #6 Intentionally Defective Income Trust Pros: Cons: • Requires trust administration for term of note • Limited audit risk, if properly valued and documented • 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
Schwabe, Williamson & Wyatt’s Real Estate and Business Seminar Series Questions? Thank you.
Dennis A. Ostgardis 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. About the Presenters