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President's Proposal Threatens Family Business Estate Plans

Among President Clinton's recent affairs of state is a scandalous attack on some of family businesses' most frequently used estate planning techniques. Contrary to the spirit of last year's half hearted efforts to reduce your estate tax burden, the President's 1999 budget proposals emasculate family partnerships, the $10,000 annual gift exclusion and personal residence trusts.

There is a common thread to these planning techniques. They represent ways to give property to your kids while restricting their control over it. President Clinton's proposals strengthen arcane tax rules and protect the government from minor tax revenue losses. But, they are bad social policy and will be extremely detrimental to family values.

$10,000 Annual Gift Exclusion Attacked

For obscure reasons, only "present interest" gifts qualify for the $10,000 annual gift exclusion. To be a present interest, the donee must receive the immediate possession or use of the property. Outright gifts and gifts to custodial accounts for minors work fine. But, gifts to trusts typically do not qualify for the exclusion because the trustee stands between the property and the donee.

I shudder to think about what would happen if my wife and I give $20,000 to each of our two young teens every year. By the time they reach adulthood, the accumulated gifts plus income and appreciation could be huge. My oldest son would buy that Ferrari of his dreams and my youngest would buy every video and computer game in existence.

So, wouldn't I be wise to make the gifts to a trust and tie the money up until they become responsible adults? Say, age 55. Unfortunately, my common sense desire to restrict access conflicts with the present interest requirement.

In the 1960's, a clever taxpayer named "Crummey" added a special provision to a trust instrument. The provision gave the beneficiaries the right to withdraw each gift for a limited time (e.g., 60 days). If the donee did not exercise it, the withdrawal right lapsed and the property stayed in the trust until the trustee chose to distribute it. As guardian of the federal fisc, the IRS objected. However, the courts concluded that, despite the lapse, the withdrawal right satisfied the present interest requirement. Concerned parents rejoiced.

Powers Rarely Exercised

The President now observes that very few Crummey powers are exercised. Well, duh! That's the idea. We parents hold pretty big hammers over our kids' heads. "Sweetie, the first gift you actually take will be the last gift I ever make." Apparently, Mr. Clinton views this threat as child abuse.

In recent years, clever advisors have taken advantage of Mr. Crummey's ingenuity to increase the number of annual tax free gift exclusions. Suppose you create a trust primarily for the benefit of your three children. You name your siblings' 10 kids as contingent beneficiaries just in case your children die prematurely. Then, you grant withdrawal rights to all of them, plus your butcher, baker and candlestick maker.

Arguably, you get 16 annual exclusions, meaning a total of $160,000 per year of tax free gifts. The IRS objects to exclusions other than for your kids because they are the only likely beneficiaries of the trust. Too bad, the courts approve the extra exclusions for your siblings' children (but probably will nix those for the butcher, et al).

While we can debate the merits of allowing the exclusions for your siblings' kids, the President will settle the question with a meat cleaver by disallowing all Crummey powers. My sons are jumping up and down in anticipation!

Retroactive Effect

The President goes a step further. Remember that insurance policy you bought in trust to help pay your estate taxes, satisfy your buy/sell agreement provisions and provide liquidity for your family? Over half of those responding to the 1997 Arthur Andersen/MassMutual American Family Business Survey use life insurance trusts. Most of those trusts likely contain Crummey powers to qualify the annual premium payments as nontaxable annual exclusion gifts.

The President grants no leniency for existing trusts. If his proposal is enacted, subsequent premium payments will eat up your $600,000 lifetime gift exemption and may result in gift tax. Or, you can let the policy lapse. Not surprisingly, the insurance industry is going berserk.

The President's attempt to plug the perceived Crummey abuse flies directly in the face of his oft stated desire to protect and foster family values. It threatens past estate planning commitments made by many families and will substantially increase the cost of future estate and business planning. Wouldn't better social policy be to eliminate the present interest requirement rather than strengthen it?

Family Partnerships Nuked

Family partnerships are used by almost 20% of the family businesses responding to the 1997 Arthur Andersen/MassMutual American Family Business Survey. Due to their popularity, the IRS recently launched a frontal assault on their gift and estate tax benefits. Because the IRS is losing the battle, the President is joining the fray.

A partnership is a convenient way to manage a family's wealth. It centralizes control, provides economies of scale and offers protection from family members' spendthrift ways. Simply stated, the kids can't "spend" a family partnership interest and can't control the partnership's assets.

For these reasons, family partnerships provide gift and estate tax savings. A partnership interest cannot control and is less marketable than the partnership's assets. These deficiencies justify valuation discounts, which range from 25% to 60% or more, when partnership interests are transferred by gift or at death.

Current tax law gives the IRS only feeble arguments to disallow these discounts. According to the President, family partnerships are ". . . eroding the transfer tax base." Don't overreact, Mr. President! Gift and estate taxes contribute only about 1% of total federal revenues.

The proposal disallows these discounts, except to the extent that the partnership owns an active business. Cash, marketable securities, real estate and artwork are not active businesses.

Never fear, savvy advisors simply will "stuff" nonbusiness wealth into other entities, like Subchapter S corporations. Or, they'll encourage you to leave earnings in the business so that the cash will be discounted when you transfer the business' stock. Forget the idea of building wealth outside of the business to provide retirement security or to equalize bequests to children who should not inherit stock.

The legislative writers likely will anticipate "entity stuffing." They'll write rules to disallow corporate stock discounts relating to nonbusiness assets and excess capital. Sound complex? The precedent exists. Take a look at the 1997 Tax Act, which denies the family business estate tax exclusion for the nonbusiness portion of your company and any capital beyond its reasonable business needs. Imagine IRS agents asserting that your business has excess capital!

No Place Like Home

To add insult to injury, the President goes one step further. He proposes to eliminate the qualified personal residence trust (a.k.a. "QPRT"). QPRTs were specifically authorized by Congress in 1990 to ease the gift tax burden of transferring a principal residence and a vacation home. As it turns out, too many people are using it exactly as Congress intended. To further family values, Mr. Clinton will increase the cost of transferring your home to your kids.

Do you see just a little something wrong here? Is it possible that the President has lost sight of important ideals in his search for tax revenue? Partnerships and trusts are convenient and appropriate ways to separate the kids from the business and other property. There are very legitimate family, business, investment and social reasons for doing so. Is plugging relatively minor leaks in an onerous estate tax really worth the impact of these proposals?

I suggest that you tell the President and your Congressmen that these proposals will adversely affect your family and business. Make this your affair.




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