Fearing the gift tax exemption was about to drop from $5.12 million to $1 million, the children of a wealthy California woman hired a lawyer late last year to determine whether there was something their mother should do to soften the tax hit.
The woman, who had no college education, had made her fortune in Pasadena, Calif., real estate by convincing a bank manager in the 1950s to lend her money to buy property on the promise that she would sell it for a profit and repay him, which she did. She then bought another property, and then another, eventually accumulating about 10 income-producing properties, off of which she now lives. Her son and daughter, on the other hand, have not done as well. Now nearing retirement, the two children, who don’t speak to each other, feared if the gift tax exemption shrunk, the amount of money they would inherit would be a lot smaller. They hired the lawyer to make sure that didn’t happen.
But the lawyer advised them to wait until December before taking any action. He reasoned that Congress might wind up extending the Bush tax cuts, making it unnecessary for the woman to give away any of her assets at this time.
“They were told, ‘Don’t rush into anything. Things will work themselves out,’” says Samuel B. Ledwitz, an estate planning, trust and probate lawyer with Bezaire, Ledwitz, and Borncamp in Torrance, Calif. He notes that back in 2010, Congress waited until December 17 before making last-minute changes to the tax laws.
But as the weeks in December went by and Congress failed to act, the woman’s children grew more and more anxious, wondering whether their mother should gift them some of her assets while she could still do it tax free. On the last day of the year, they encouraged her to finally pull the trigger, and so she did, giving them $6 million in property. A month later, Congress didn’t just renew the $5.12 million exemption but bumped it up slightly, to $5.25 million. The woman now regrets her decision, as the properties she gave away provided her with most of her income. She now fears that if her health fails, she’ll have no money to take care of herself, and that her children, because they aren’t on speaking terms, will each think the other is going to care for her.
“They didn’t take into account the family dynamics. This lady, when she goes to sleep at night, does she feel secure? That’s worth more than what she’d pay in taxes,” says Ledwitz, who was hired by the woman to reach an agreement with her kids. “A lot of attorneys forget it’s not just about the money.”
Ledwitz says the children could always gift the assets back to her, but they’d then be using up their own gift tax exemption. He doesn’t know if they’d be willing to do that even if they could. The three are currently in talks with any attorney to see whether the children will at least be willing to come up with a payment plan that guarantees their mother some income from the assets.
“I think we’ll get a deal that will make her feel OK, but she’s not going to get the assets back,” he says.
The mother from Pasadena is not alone. Fearing the gift exemption was about to shrink, many affluent individuals quickly made gifts to their children and grandchildren in late December, as if throwing assets over a wall, to get them out of the estate before the new tax code kicked in. Nearly 26% of estate attorneys surveyed in January by WealthCounsel LLC and Trusts & Estates magazine said their ultra-wealthy clients took advantage of the $5.12 million gift tax exemption before it expired. But by January, when it became clear the tax law wasn’t changing after all, some began to regret handing over their assets, and they now want them back.
One attorney says he had a client who boldly decided to revoke or rescind all of the estate documents they had drawn up in December, claiming his attorney had changed the trust at the last minute and “messed up the plan he asked for.”
Another attorney says his client had signed all of the estate documents they had drawn up in December and was about to place them in the mail but had forgotten. Once mid-January rolled around, the attorney reached out to ask where the paperwork was, and the client told him he’d never signed the papers and that he’s now had a change of heart.
“I’m glad I’m not stuck with that ethical challenge,” said an estate lawyer familiar with that attorney’s situation.
David Platt, an attorney with Henderson, Franklin, Starnes & Holt in Sanibel, Fla., says he has several clients who regret making gifts last year. Two of them are couples in their late 70s or early 80s, both of whom gifted about $10 million to their children and grandchildren. While both couples still have more than $20 million each in the bank, they fear that if their health fails, their money is going to run out.
“Both clients are of the belief that had they known that the tax credits were going to stay the same, they would not have engaged in the transfer,” he says.
Platt had another client who simply wrote a $5 million check to his children, and shortly thereafter was presented with an investment opportunity in which he could not participate because he no longer had enough cash. He asked Platt whether the children could return the money. Platt told him if they did, they’d likely wind up squandering their own lifetime gift exemption.
“He passed down that investment opportunity to his children, but I think he would have preferred to take the opportunity himself,” Platt says.
The Biggest Regrets
Those who most regret gifting assets late last year are likely to be people with about $3 million or $4 million who gave away a large proportion of their income-generating assets—thinking the exemption was going back to $1 million—and are now left with very little.
“I’m going to feel more pain if I’m 60 years old, and I’ve transferred two-thirds of my wealth to other individuals, and now I realize it wasn’t such a good move,” says Carl Sheeler, a San Diego-based valuation expert who founded Business Valuations. “Because I now have 25 to 30 years left, and I don’t have the kind of wealth I could have had, and it was all because I was motivated by tax savings.”
Another group with regrets may be those who received assets and now find themselves with the cost basis the donor had when they carried the asset—a situation that may cost them a lot of money in capital gains taxes down the road. If a gift is made after someone dies, the asset receives a step-up in basis, meaning its basis, for accounting purposes, is whatever the asset was worth when the donor died. However, if a gift is given while the donor is still alive, the asset carries the basis it had when the donor carried it. So if someone gave their child a $2 million house last year that had a cost basis of $100,000, when the child goes to sell that house, the capital gains taxes they must pay will be based on $100,000. If the house sold for $2 million, the child would have to pay capital gains on $1.9 million. If the child had inherited the house after his parent died, on the other hand, the cost basis would have been stepped up to about $2 million, or whatever the house was worth.
Some people didn’t so much regret giving away assets unnecessarily as they did paying fees when they didn’t have to, and those fees last year were as much as $30,000 including costs for lawyers, accountants, valuations experts and appraisers. Appraisers were in such high demand late last year that one attorney says he was told it would cost $2,000 if the client wanted a report in three weeks and $3,500 if he wanted it in two. The usual fee is about $1,000, the attorney says.
“I like to think as attorneys, we didn’t take advantage of people wanting to get these deals done quickly, but I’m sure some did,” says John Palley, an estate planning attorney with Johnson, Fort, Meissner, Joseph & Palley in Sacramento, Calif.
Like a lot of trust and estate lawyers, Minneapolis-based attorney Christopher Burns says in the final months of last year he was putting in 14-hour days. In December, he worked every day but Christmas Eve and Christmas Day. And on the last day of the year, he remembers driving all over town picking up paperwork that had to be signed, or retrieving PDF files from clients so that all the required documents were in client files in his office by midnight.
“It was the craziest of crazy years in all my 14 years of practice,” Burns says. “Albeit for the billable hours, I hope not to replicate that period.”
Like a lot of estate attorneys, Burns says a few of his clients now wish they could unwind the gifts they made. People don’t like to give up control of their assets, regardless of the tax laws, he says. And with the tax laws having remained the same, it appears they relinquished that control unnecessarily.
Burns says he had a lengthy conversation with one particular client, who said had he known the exemption would have remained, he would have done things differently.
“He said he wished he had a DeLorean,” Burns says. “I wasn’t expecting a Back to the Future reference from a client this age.” (In the 1985 movie, a modified DeLorean is the time machine that transports the lead character back to 1955.)
He seems to be feeling particularly nostalgic about the property he gave up, Burns says.
“People get attached to real estate, like a family cabin that might have special and unique memories. And he’s no longer controlling that real estate now,” Burns says.
But at least in his case, the children are likely to let their parents continue to use the asset as if it were their own.
“And I’m sure if the boat needs gas, the kids are going to ask dad to fill it up,” he says.
IRS May Create Gifting Regrets
Some clients may see their hastily built 2012 gifting plans undone without any effort at all—courtesy of the IRS.
One of the most popular structures used last year to gift assets was the family limited liability partnership or company, which enables a parent to give away assets while retaining a certain degree of control. This allowed parents to get some money out of their estate but still dictate how the asset or company is handled.
Some attorneys question whether the family limited liability partnership structures will hold up to IRS scrutiny.
“There are a number of cases that don’t hold water,” says Ann-Margaret Carrozza, an estate attorney in Bayside, N.Y., and a former New York State legislator.
Others, however, disagree, noting that the plans follow the letter of the law.
“It’s completely legal, even though the parents retain a fair amount of control,” says John Palley, an estate planning attorney with Johnson, Fort, Meissner, Joseph & Palley in Sacramento, Calif. “The parents can remain in charge of the operations of this limited corporation, the decision-making in terms of investment choices, and they can skew income in their favor. However, what they cannot change is the ultimate beneficiary.”
Part of the reason the structure was so popular, aside from the retention of control, is that because the interests in these partnerships are considered illiquid, the IRS discounts the value of those assets. Someone could gift about $10 million in LLC interests to a relative, but it might only be valued at, say, $6.5 million. The result is that an extra $3.5 million can be transferred, without being taxed at 40%—or as one attorney explains, “It made $3.5 million disappear.” That’s about a $1.4 million tax savings.
“I would think for most attorneys, that was the major device used,” Palley says. “The government is acknowledging that even though on the surface the appraisals make it look like it’s worth $10 million, the government accepts a discount analysis.”
Palley says there’s no set number for the discount, but a 30% to 40% discount is well within acceptable levels.
Carrozza says 90% of these types of partnerships are audited, largely because they were abused for so many years. In the past, unscrupulous or uninformed promoters would sell high-net-worth families on the structure, enabling them to put assets into the partnership and then take back almost 100% of the partnership shares, she says. Some made an effort to split the shares more equitably but then created voting and non-voting shares and would give, say, five voting shares to the person who created the partnership and 95 shares to everyone else, though those shares would have no voting rights.
“I would tell families, don’t try to be cute,” Carrozza says. “If you want to get a lot of the family limited partnership interests out, then be more reasonable in what you’re transferring. Maybe transfer 50% instead of 95%. And don’t take back more than 50% of the income or management decisions.”
David Platt, an attorney with Henderson, Franklin, Starnes & Holt in Sanibel, Fla., agrees, noting the case law is chock-full of challenges to estates that have family limited liability partnerships.
“When you report them on your tax returns, the IRS audits each and every one of them to make sure it’s properly structured and properly administered,” he says. “I don’t do a lot of them for just that reason. The client needs to understand the significant risk of audit if you try to retain control.”
Platt says if the transactions aren’t structured properly, and the person who set up the trust retains too much control, it may very well be brought back into the estate, and relatives may not know that’s going to happen until after the trust’s creator has died.
But the problem isn’t just with the family limited liability structure. Some believe the IRS is going to have a field day looking over all kinds of transactions done late last year. Because even though there is a whole cottage industry dedicated to helping wealthy individuals reduce their estate tax bills, the tax code explicitly states that trusts or partnerships cannot be created explicitly for that purpose.
“Tax avoidance can be one purpose, but it can’t be the primary purpose,” says Carl Sheeler, a San Diego-based valuation expert who founded Business Valuations.
Sheeler says that while the IRS is always watching out for this sort of thing, it is going to be monitoring particularly closely this year.
“I say that with full knowledge of having had discussions with the regional director of the [IRS’s] Western region,” he says.
While some will claim their deals were done because of “succession management” or that years of planning had gone into them, many of them were done in the final days of December. Sheeler notes that the volume of business at his firm in December was six times what it was in December of the prior year.
“When all these deals are done in December to take advantage of this situation, the ability to argue that the motivation wasn’t just tax driven gets smaller,” he says.
Moreover, transactions were structured so quickly in the final days of 2012, some may not have followed proper procedures, attorneys say. A lot of people cut corners, says Samuel B. Ledwitz, an estate planning, trust and probate lawyer with Bezaire, Ledwitz, and Borncamp in Torrance, Calif.
“For the real estate appraiser, maybe they got their buddy, who is a realtor, to write them a quote instead of getting a certified appraisal from a licensed appraiser,” Ledwitz says. “If you don’t substantiate properly, the IRS may disallow some of the discounts.”