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hi everybody it's steve goran welcome to um this teach daily pass through entities held by trust formula transfers in estate planning and business gets with selling when selling a business so you should have the slide from your resource widget and then also you should also have a download on my newsletter which which has the different articles that support this particular webinar so before we begin i want to cover some other housekeeping items if you have any questions during the webcast you could submit them through the q a widget at the bottom of your screen we will try to answer your webcast but if a fuller answer is needed or i run out of time then i'll answer later by email um you can you um you can also find the materials besides on our resource widget you can find them on our website and encourage you to download any resources and links you found useful you can find additional answers to some common technical issues located in the help widget in the bottom of your screen this webinar is cle accredited in california illinois and texas for 1.5 general credit and a missouri for 1.8 general quarter we reward clea based on attendance for the entire 90 minutes from time to time you'll be required to click a pop-up screen to reflect your content engagement the certification icon located at the bottom of the screen will tell you if you met our criteria for awarding cle it does not include the certificate of attendance verify your attendance your certificate will be mailed emailed to you later this afternoon this webinar is being recorded and will be available within 24 hours you can access it from our website www.topsailcobra.com all in attendance will also receive a link to the report opinions and appreciate your participation in the course okay so let's now go um through the slide and [Music] before i get into it um just mention about um you know we have a lot of potential changes coming up with the with the uh with the next election um and and i want to remind everybody what the guy overriding principle of tax reform is which was coined by senator russell long who chaired the senate finance committee back about 40 50 years ago so his print guiding principle tax reform is don't tax you don't tax me tax the man behind the tree so i think that's what you're going to have to look for um going up uh going forward with our with our changes in the law and we really don't know what's going to happen um after this after the election either all right so slide two overview um i'm going to talk about consequences of trust owning interest and as corporations and partnerships um which is going to be an overview of my materials it's going to be more like how you can use my materials as a good resource i'll have some substance in there too but i really want to kind of guide you through it because a lot of people find it intimidating to go through 2500 pages and even with the table of contents and i want you to know what's there and and some some good issues spotting so that's going to be the first segment the second segment will be on formula transfers and we have two cases in 2020 that inform when you make formula transfers and of course the formula transfer is when you are wanting to transfer an interest in something that's hard to value and you would like to try to protect the client against um irs audit results being being bad because you just don't know what the value is um and no matter even if you get an appraisal you don't really know what the value is or it says it what what they agree what it is um and then then the third book the third segment will be on business gifts and alternatives and so this is the idea when you're selling a business and the employer would like to give some money to the employees kind of kind of cut them in on some of the success from the sale and what's what's kind of what's the best way to do that and um we have some from a very clear statutory law but we also have a lot of case law and there's a 2020 case that informs some of the issues there that i'll also mention okay so that's the overview and and by the way everything that i'm saying here i'm doing this as a kind of a condensed thing for each of these segments but i will have longer um programs that will be qualified for cle and cpe credit and you'll see at the very end of the slide a link to those so i know we're doing just kind of the highlights here and and for those who want more in-depth they can they can um they'll look at the last slide and you can um go and spend some more studying okay so we're on slide three now so trusts owning interest and pass-through entities so um the way that my materials work is um you can see by the way that there's a parenthetical here like you see that roman roman numeral 3 a3 so that's the reference this in my 2500 pages materials that that covers that particular area so my trust holding stock in s-corps basically goes through the various nuances of that not only who can hold stock and when the elections need to be made but also the income tax consequences of it and some very important planning issues and and i do have some more slides that go into that in more detail so i also have another provision that talks about um code section 678 trust so those are trusts where the beneficiary is the deemed owner of the trust and we and we talked there about what it takes to make the trust be a deemed owned beneficiary and there's a lot of people who are trying to do a lot of fancy planning and a lot of times they overlook some of the some of the details on um whether the trust is a wholly owned grade or trust for all purposes or just for some purposes so those the offer the some purposes may be reporting annual income versus all purposes being for sale purposes i've got some materials on the code section 199a deduction and i'm not really going to talk about that and focus on that here um that's the 20 deduction for qualified business income uh i came in with the 2017 tax reform and i saw a summary of biden's tax plan and i figured that they would just you know raise the corporate rates and then get rid of this this deduction here because this deduction the purpose of this deduction for qualified business income is to try to put people and pass through entities kind of on a level playing field with people who are who have c corporations because c corporations had such a radical radically um significant tax cut and what summary i saw said that biden was going to increase the corporate rate from 21 to 28 percent but he wasn't going to do away with this deduction um and instead he was going to phase it out and say that you get the deduction at the lower levels but at the higher levels you don't get it um so i thought that might just be going away um if the democrats get in power and they just want to repeal like everything that happened in 2017 but apparently not apparently he's interested in keeping this um so my materials go through extensive coverage of that and it includes the legislative history the code the preamble to the proposed regulations the preamble to the final regulations and the final regulations um so all of that is in those materials um and um just in this past quarter we did get final regulations on some aspects of the qualified business income those they're mainly we're dealing with how you treat losses and carrying forward losses for purposes of the qualified business income deduction um there were also some things that dealt with on the separate share of rule and chair remainder trust um i don't think those are really all that significant and they follow what the proposed regs did but nevertheless you do have complete coverage there na stuff is pretty much up to date so then there's the net investment income tax and we're going to go through some of that as well and trust solving a business i'm going to go through some more slides that go through these details a little bit more so trust holding stock and that's what we're creating um how to qualify risk and perfect to measure and one of the big issues there is just think about how we make the trustee a whole young grand tour trust um so we don't want it to be something that changes beneficial interest but then the group can have the ability to change that or or otherwise they'd be ruling risking quote section 2036 inclusion so what we do for that is you um you will then um consider what what what ways to do it the way that most people use is a swap power a power to substitute assets of equivalent value and a lot of people rely solely on that sometimes i'll have the power to borrow as well but the bottom line is if you look at the regulations on this it says that that whether it qualifies for grants or trust treatment or not depends on the facts and i'm not really all that comfortable with that uh in terms of if i wanted to give somebody a hundred percent guarantee on that um if the irs were to find that the trust were only 99.9 owned um then the irs could could say that it's not a qualified shareholder now as a practical matter the irs isn't going to be doing that but what happens is when you are selling your your company and a strategic buyer they have their tax advisors scrub everything really thoroughly and they look for any risk whatsoever if they find any risk whatsoever relating to the s election then they can give you a hard time about trying to get the deal closed and so so then you may need to get a private letter ruling and private letter rulings can take like six months or so and i'm not sure what the framework is now with the pandemic but six months is typically what the irs will quote you on the phone um sometimes you get into rushing through but um if you have a strategic buyer in the wings and and you're waiting for six months for a private letter ruling imagine that that strategic something happening and you lose that strategic tire during the time you're waiting for the private letter ruling so that could be a real disaster so as a safety measure and make an electing small business trust espt election um and uh my materials go into that some more um but i pretty much regularly been doing this whenever i have an irrevocable branch for trusted holds stock s corporation i will do the esbt election okay next slide i kind of mentioned all of these resources before the first two bullet points um the third the third bullet point was interesting there was a private letter ruling or there were some there was a more than one and um they they had a qualified revocable trust that elected to be taxed as an estate and um and then there's a then once the 645 election terminates so then you need to um do something about your f election here was they they made the election and then they they transferred the stock to trust and another part of this rule says that when you transfer um stock to a testamentary trust or you made your election to treat the trust your revocable trust is in the state so it's being transferred from an estate the downstream trust the trusts that are that are created when the revocable trust terminates those downstream trusts have up to two years to make the qssc or esbt election um and for those who don't know what the qssp already speed the election is i don't have time right here to go over that because this is more of an overview here but the materials go into that in detail and but you have to make one of those elections and in this case they hadn't made the qsst or esbt elections um in time after the two years from having transferred it to the downstream trust and so they got some inadvertent termination relief i don't think that's really all that significant but i just want to point out that people just didn't pay attention to these deadlines now for me if you go to slide six um i kind of even take the opposite approach of what they would of what these guys did they waited the last minute and even beyond for me i get concerned about the income taxation so if you have an s corporation and it distributes less cash than the k1 income then you have some tax issues that's very common like if you have somebody who had a million dollars of income they might distribute only four hundred thousand dollars just so that their can pay the taxes and they might reinvest the rest of 600 000 in the business well if you do that then how much can you distribute to the beneficiaries well if you distribute the whole 400 000 to the beneficiaries then the trust still has 600 000 left and and has to pay tax on it and have to pay the taxes so ultimately what would happen is um in that example you're going to keep the whole 400 000 inside the trust to pay the taxes on the 1 million and you can get everything taxed at the highest bracket so contrast that if you had a qualified subtract for estrus or 2sst and with that the beneficiary is the deemed owner of all the k1 items from regular operations and in that case you if there's a million dollar k1 and a 400 000 distribution the beneficial gets that 400 000 distribution and has to pay the tax on the full 1 million dollars trust doesn't have to pay any taxes but the beneficiary when they when the beneficiary gets that million dollar k1 they have the full run up in the bracket um so whatever lower tax brackets they have to be fully used and and so you're not going to have everything taxed at the highest bracket so i like the idea of quickly funding any downstream qssts so we can get all the income tax at their lower personal rates so contrary to the idea of putting it off to the last minute make your election i like to um as quickly as as is advisable under the situation um and then um and then make the qssc election and get that income tax at low rates as soon as we can now that's not always the smartest thing to do and my materials kind of go into the pros and cons of it okay slide seven qsst and espts so you can see there i have a whole variety of issues that we go through um and i'm not going to go into them now i just want to let you know that's there and and it's a good idea to think about it i mentioned the qsst the trustees owned by the beneficiary some people may be tempted to to create to create an s corporation and a qsst just to get the the favorable income taxation but there are some disadvantages to that and again um just go through the materials and take a look at those um slide eight code section 678 the fisher dean's own trust um so i kind of go through how to make it apply and it's particularly that portion rule that applies when the withdrawal right doesn't apply to a trust so if you have a withdrawal right over a million dollars and the trust grows to 1.2 million dollars and then your million-dollar withdrawal right lapses um then you only have um grantor trusted to 10 12 of the trust and and so uh you you do have some significant issues so the materials go through that they go through asset protection issues um there's a 2020 private letter ruling which was obtained by a jonathan raccoon um and an act tech fellow a very smart guy and the the uh basically in that case the beneficiary is the right to withdraw all the assets except for an llc that the trust owned and but then when the llc would get sold they had the right to the sale proceeds so what happened is the trust sold the llc to another trust that was deemed owned by the benef by that beneficiary and the letter ruling said that there was um that that that was a grantor process to the sale because the sale proceeds belong to the beneficiary and the the buyer trust was deemed owned by the beneficiary um so i think that's a pretty unusual situation but it is the most recent development in that area okay code section 199a deduction i already discussed that by 10 the net investment income tax um so for those of you who haven't heard me talk about an investment income tax before um i'd like to remind you of the the the movie might be python and the holy grail um and if you abbreviate net investment income you'd abbreviated nii so for those who know mighty python holy grail you would know how to pronounce that which is he and back over 40 years ago they knew that meat would be a bad word so this 3.8 net investment income tax applies to business income and and i have a lot of materials that go through that i've really spent a lot of time focusing on it i know passive income generally is going to be subject to the 3.8 tax we talk about rental income which is generally per se passive um when you sell your your partnership or f corp talk about whether the gate how much of that gain is subject to the investment income tax and how much is not and what various strategies to consider to minimize the 3.8 tax fiduciary income tax plays into a 3.8 percent tax because whatever the trust distributes out you would potentially tax that at the beneficiaries level and so you look to see whether beneficiary subject in that best income tax whereas whatever the trust retains you then apply those rules to that so uh so you see i have some resources there that kind of talk about this correlation of the future income tax rules with the net investment income tax side 12 passive loss rules i have extensive coverage of the passive loss rules in my materials again and kind of that was one of the things i when the 1986 act passed my practice accounting i paid a lot of attention to them and then i went to practice law the timing of taking the losses or not that was just something for the accountants to figure out and as a lawyer i didn't really have to pay as much attention to it but now i do because there's a current tax it's not just the timing of the taking the loss it's the 3.8 percent tax so in 2013 i when the net investment income tax rex came in um i did a lot to pass a law school and whether a trust is actively or significantly participating or purely passive i have a lot of materials on that for the net investment income tax the um the issue is not material participation as much as it is something else called significant participation so in terms of making the um the the income being non-passive the passive officer was basically have kind of a heads i went tell you lose approach to the passive loss rules if you view them in uh as an in isolation when they got passed in 1986 we didn't have an investment compact so what they wanted to do is say okay it's going to be hard to deduct a passive loss but we really don't want the income to be characterized as passive income because then you can offset passive losses against it so what they said is you have to work for more than 500 hours in order to make a loss be non-passive but if you work more than 100 hours then we will re-characterize your passive income as being non-passive income because we don't want to have a passive income generator um so that that was called that's called significant participation activity when you participate from more than 100 hours so my materials spend a lot of time going through participation by a trust um and and what it takes to to get there um there's a lot of lore there's a lot of kind of common knowledge there which might not actually be correct in terms of what's out and out there and and um i encourage people to look at the materials to have a more full discussion over some of those issues another interesting issue is that depreciation expenses actually can pass through directly to the beneficiary so when the trust gets a k1 from a partnership for example when you have a non-grantor trust that owns a partnership then generally the partnership needs to separately state what the depreciation deduction is because a trust doesn't reserve for depreciation will generally be passing through the depreciation deductions directly to the beneficiaries the depreciation deductions in fact don't even appear on the trust income tax return if the trust is distributing all the income the entities um so what you do is the trust will simply on its okay one of the beneficiaries say okay here's a separately stated deduction this is the only place in our tax law where a trust can pass out a loss before the trust terminates pretty unusual rules there and then the question is suppose the trustee is not necess may or may not be participating but the beneficiary does participate in the business then um can the beneficiary deduct that depreciation and my answer to that is yes i think so but the the materials go into that trust selling a different business go through there all so we're on slide 3513 so we go through all those a lot of different of the issues that go there um one thing with the qsst generally that's going to be a mandatory income trust it doesn't have to be mandatory income if you pay off to come out but most people will just make it be a mandatory income at least while it holds the stock as mandatory income and then when you go to sell the business the the income from the sale of the business actually winds up being a trust item it doesn't it doesn't it's not treated as owned by the beneficiary in fact if the if you're selling the business and there's a deemed sale of assets and and the whole thing is the deemed selling liquidation of the business from the from the seller's viewpoint um then what happens is that the k1 income is attributable to the sale the business asset is actually supposed to be staying in at the kfe at the corporate at the trust level it doesn't get passed through automatically the beneficiary but you might want to pass it through to the beneficiary indiana and you could do that either by making a distribution an actual distribution or after the fact you could say hey is there a way that we can recharacterize the the gain on the sale as as reduce your accounting income and then that was a mandatory income trust you can go ahead and get the deduction for distributing that gain from the sale out to the beneficiary well talking back to the discussion before about suppose you had a million dollar k1 and a 400 000 distribution well 600 000 of that income is being reinvested so from the beneficiary's viewpoint it might be only fair to give the beneficiary the benefit of some of that reinvested income so when you're going through after the fact and you might want to be pushing some of the gain from the sale out to the beneficiary if that's a desirable thing to do then just then then just go and make what we call an equitable adjustment and that's basically saying that all this income was reinvested but the beneficiary paid tax on it so it's only fair to distribute some of that income to the beneficiary and so you can re-characterize some of the gain or sell those ass as the distributions that were required to be made to the beneficiary and then have that flow out to the beneficiary okay let's go on slide 14. and then investment income tax issues um and and i'm the materials go over that so i'm not going to spend time on that so that completes the coverage of that particular topic so i'm going to go on to define value clauses so we're on slide 15 and we're going to talk about why to use them and kind of do a brief comparison to graph we'll talk about a formula it describes how much is transferred with provisions for where any excess goes we'll talk about using a disclaimer we'll talk about using a formula that describes the purchase price i will talk about achieving finality and again there are two 20 20 cases that dealt with some of the form these formulas and so i'll do a reference to those two so slide 16 why do you use it so if you have property to sold to an irrevocable grant or trust and that's a difficult to value asset then you know valuation you know even though we try to be objective with it there's a lot of judgment calls that go into it and the irs can have a different judgment call than our fraser can have and now there are some taxpayers who want to do try to game the system to this degree but for most of my clients it's just a matter of hey i want to do a sale i don't care what the sale price is i just want to do the sale so so i can get the asset into the trust and and then we'll deal with paying down the note you know a sale to an irrevocable grantor trust it's going to get re the note's going to get repaid through tax distributions you know over the you know it's often over five or six years um but i usually make my notes nine years just in case um but um but it's going to get paid off that note's going to get paid off regardless of the number um if it's a if it's a closely held business that's just um you know it's not marketable it's not doesn't have access to the you know to the stock exchange that type of thing so clients just want to sell it for whatever the number is for the fair market value and if the value is higher than they thought then maybe it's an extra year or two to pay off the note but there's really no consequences to that otherwise um in terms of they don't really care what the value is um now at least that's what i try to discuss with clients and make sure they understand that and that you know the irrevocable winter trust will work as long as you give it enough time and come to us in advance long before you die so so we're just trying to eliminate uncertainty in tax results we want to sell it for whatever the share market value is we don't care what that is um so what we want to do is we want to sell it for the finally determined if tax purpose and give text value we're going to get into that language in a little bit so slide 17. now a lot of people tell graphs because that does away with all of the valuation issue on the initial gift to the graph but to me that's only part of the game the there are there are consequences to administering the grant and determination of the grant you need you need to consider um so one of the things is that if you have a foot fault and like you don't maybe you don't distribute your um your grant payment on time maybe you have um you what maybe you make a distribution that suppose you're paying your annuity and kind all right so i try to avoid that what i'll do is if you're gonna if you're gonna do a grad for business maybe you do it like over seven or eight years and then i'll have the first few years of payments will be all in cash and when we do what's called a graduated grad each year you can you can increase the payment by 20 so you start off with a really low payment and the payments get higher as the graph goes along so the first few years are relatively low payments and you can pay that often with a grad income and and then you can make cash payment so that's what i prefer to do suppose somebody did a two-year grant for their business and and um now if they're going to sell their business in the next you know few months and they do the two-year grab then that's a great safety valve but let's suppose say that the business doesn't sell and you don't have the cash to pay make the annuity payment and then you have to pay with um distributing some of the business back out to the grantor so when you do that you are giving an asset with an uncertain value in exchange for this annuity payment of a dollar amount so what position might the irs take for something like that well if the let's suppose the annuity we're gonna be a million dollars if the irs says well that property that you gave back to the gr to the grand tour is really worth only eight hundred thousand dollars um because because you yourself said there's lots of valuation discounts um and we think there's more than what you said so so now there's two hundred thousand dollars shortfall in your distribution so you didn't administer the graph correctly because you didn't make the whole payment when you were supposed to or they could say well that property distributed was worth 1.2 million but you're only supposed to get a million so you've given 200 000 extra but you've really kind of pre-paid the grad obligation and the regulations require you not to prepay the grad obligation so you've busted your grad so those are ideas that the irs might make i mean i think that there's more worry about it than there's actual cases but you know i worry i mean you're worried about evaluation anyway that's why you did the graph but so aren't you going to be worried about whether the annuity payment was correct or not so so that is a concern with that um there's also uh an idea you you can't you can't turn off the grandchild trust powers for a grant because the power to get the the ability to retain right to get the annuity payment back is a grand or trust feature and i think about 15 years ago there was a case somewhere in st louis where they had what we call what they call an exploding graph they put some s corp stock into the grat and the s corporation was so successful that the k-1 income was huge and the grantor went bankrupt because the grandchild couldn't afford to pay the taxes on that now there are ways to deal with that you you could have an income tax reimbursement provision built into the grad potentially but you need a plan for it um but again you can't turn off the power there's extra planning that you have to do whereas the sale to a real global grant or trust generally you structure where you can turn off the grants or trust powers now one advantage over a grant over a sale to the irrevocable financial trust is if you die during the grant term then you can get a state tax developer section 6166 which you would not be able to get if you just have the node in your estate on the other hand if you die during the grad term then you may you might have a whole grant including your estate whereas if you die with the stealthy revocable rancher trust then you might just have the note including your estate finally when the grad terminates you can't allocate gst exemption to get the fixture inclusion ratio for a grad up front within sales and irrevocable grants or trust let's suppose you had you know a you want to have a 10 million dollar deal maybe you do a million dollar gift to the trust and you sell for a nine million dollar note and if you have an irrevocable grantor trust you just declare one million dollar gift allocate gst exemption and you're done on the grant at the end of the grant term if that's worth 10 million dollars you need to have 10 million dollars of gst exemption to uh to be able to protect that from gst tax down the road so then your grad is going to step between um whatever your gst exemptions that this left that you can allocate versus part that isn't and then you have a part that's not protected from gst tax and then you have then then you have to figure out how how do you do that well maybe you're going to sell from the non-existent trust to the exempt trust there's some other issues with that too which i'll discuss a little bit later okay so on the next slide let's move on past rats so you can tell i'm not that afraid of fan of grass for wholesale businesses i like them for marketable securities but but um they're not as much for closing out businesses um but again you we all have our preferences i can't say there's a right or wrong all right so on slide 18. so one way to do a formula is to say i'm transferring for example a million dollars worth of llc interest um and and then and it's going to be based on whatever a million dollars value is is finally determined for gift tax purposes and um and so there's a case called laundry where they did something kind of a long road line and and the irs attacked it and the tax court said hey that's fine they taxpayers you know they they did their transfer they did their appraisers to try to make a good faith effort toward it we're going to respect their their cause there now the irs did not acquiesce on that case they said we think it's wrong and they explain why they thought it was wrong but they didn't appeal it so they didn't put their money where their mouth is um some people think because there's a um a tenth circuit case the king case which i really like um and um that didn't it wasn't laundry k it wasn't one laundry clause but it did provide sympathy for formula evaluation so people thought that that the irs was concerned that the 10th circuit's testing it would be something that would appeal the one that would uphold the laundry case and that would make it a more powerful thing than just being attacked by memorandum but the iris is on record they disagree with laundry there's also something in my materials there about an article that was written by austin bramwell and some other folks the question about whether a tax case can really determine what was transferred so you could read the article and decide whether you agree with austin and his colleagues or not okay so going on to like 19 uh required language required language needs to say something along the lines of as finally determined for federal gift tax purposes i'm going to spend some more time on that um later on um in this webinar uh about how the the language i tend to kind of use when i couch things um but there's a case in in 2020 the nelson case where the person said okay i'm going to transfer um you know x dollars worth or sell for maybe was a sell x dollars worth um and and and i'm going to do a business interest in that business interest equal in value to that determined by an appraiser and it pays or determined a certain amount and then the irs came in and said nope it's a higher amount and the taxpayers said well i said it would be the appraised value whatever that is and and the task force said you said it would be the appraised value whatever it is as determined by that appraiser you didn't say that's finally determined for federal gift tax purposes so you didn't use the magic language so you don't get the benefit of using the magic language you got to say it we are not going to read the magic language in there you have to actually say it so so they said your appraiser your appraiser determined the quantity of what you transferred the irs came in and proved to us it was a higher value than that so you're stuck with that okay let's go on to 20 so again we're in the formula describes how much is transferred so if you say i'm giving i'm giving away um i mean there's a couple ways to do it but suppose you say i want i'm gonna do a transfer of 5 million dollars worth of stock to this irrevocable branch of trust for my child and you say if the irs determines that there's that the value is worth more then i'm going to give the access to charity so if the transfer were for only five million dollars um then the charity really is getting nothing up front and only if iris audits it i'm going to talk about that in a mo in a moment on the next slide um but you can have this excess you can go to charity it can go to a spouse outright or to a marital reduction trust if you do a marital election trust i recommend a general power of appointment meditative action trust instead of a q-tip generally but there are circumstances when i do a q-tip as well um but i'm just saying there's some more there's some more complexities if you do a q-tip so i'll leave you to the materials to look at that you have a gift over to a grad or a complete gift trust um those have not been litigated at all so they theoretically should work but um you know just wanted to give you that caution okay now if you have the gift over to charity make sure it's a meaningful gift whether or not the irs audits in the moore case on the slide 21 it was kind of what i described to you before the gift was something that was intended to be 5 million and it said in excess of where five million goes to charity so the charity only gets if the irs audits so charity doesn't really have much incentive to get involved what's the charity going to do to even try to obtain an interest are they going to are they going to go and call the irs and say please audit my potential donor i don't think so so the tax court really didn't like um what went on that with that um it'd be better to have a meaningful gift over so that the charity has some incentive to audit um the charity itself has an incentive to kind of negotiate with it with the client what the tax what the what the gift is not i'll show you the client we'll talk about that in a moment too um but a record that demonstrated builders by the charity will make the gift more likely to be respected so give them something significant okay um 522 and the grave case the um terrible deduction was denied because um there was a gift to charity that it might have to give back and when you are going to get character production you need the chair to be pretty certain that it's getting that gift and in that case there's a there's a chance the charity have to give the gift back and that gift was that the chance of that happening was not negligible so there was a significant chance that the charity would have to give some back and so that ruined the deduction chris christensen case was a formula disclaimer that resulted in a charitable gift so if daughter disclaims any extra anything she disclaims goes over to charity so daughter can say hey i disclaim any excess over x dollars worth of worth of gifts and so that way she can um she can use this time-honored idea of a disclaimer which courts respect disclaimers regulations respect disclaimers and if you do a disclaimer then it's really not going to be argued successfully by the irs i say that if you ever if you do have a choice to do a disclaimer versus the formula gift i'd rather do a formula disclaimer than do a formula gift um in terms of wanting to have certainty on being able to win with irs but the disclaimer might not be appropriate because it depends on on where the money goes and what's the consequence of doing that disclaimer there's a better case approved a transfer to charity and a sale gift transfer and again that was based on values that finally determined for gift tax purposes so the of course respected that so on my 23 you this was one of the first charitable cases with a formula um there's a court case and what happened is the the deal was that x dollars go to the family and the balance goes to charity and after the transfer of the family the doneese and the charity obtained appraisals and figured out among themselves who got what portion of the business interest the donor was not involved in that process in any way whatsoever so the donor basically says here's the deal you get x dollars worth your white dollars worth it's up to you guys to figure out how to divide it up so there was nothing abusive from the donor from the viewpoint of the donor being able to play games because the donor wasn't even involved in how they divided it up so mccord was was a a very very interesting way to do it and um in the appropriate case that my good way to consider so slide 24 um i already mentioned about common disclaimers having long been recognized if you're doing a transfer to the trust then the question is are you having the beneficiary disclaimer or the trustee disclaimed if you have beneficiaries disclaim you need to spell out on the trust what happens in the event of a disclaimer so you might say if the primary beneficiary just claims then the trust doesn't even get to keep it and it goes to charity if you build an end then fine but if you don't build that in and you have everybody to claim including um you know people who who are not even living yet so that that might be really tough um if you do if you transfer to the trust and you want the trustee to be the one doing the disclaimer because you don't have to get everybody to sign off and then you should expressly authorize the trustee to disclaim so i just want to make sure that i'm clear because the second bullet point looking at it now is a little bit ambiguous if you transfer to the trust there's two different ways to do it one is the beneficiaries is claim the other is the trustee the claims if you are going to do it with the trustee disclaimer then you should expressly authorize the trustee to disclaim because um the the law out there is not necessarily clear as to whether just a trustee has a power to disclaim and just think about the idea the trustee has the duty to protect the beneficiary's interest if the trustee is disclaiming then they're moving money away from the beneficiaries so it's kind of dicey to get the trustee to disclaim so it's definitely possible it's definitely something that i've seen done before and it has worked okay before but there's there are a few issues you have to think about so the next issue is adequate disclosure on gift tax returns so all the stuff that we were talking about is finally determined for gift tax purposes the only way it can ever get finally determined is if you file a gift tax return so when i do a formula transfer i also require the person who is the donor for for gift tax purposes they sign off on that agreement that they personally agree to file a gift tax return so that way we can get the statute running so we can figure out what is finally determined if you have a sale to an incomplete gift trust um there's some there's some arguments as to whether the the um filing a gift tax return reporting a sale to the complete gift trust will actually work to run the statute and that's in the materials i'm not going to go through all the details right now i just want to let you know about that i mean i tend to make sure that there's going to be some substantial part of of anything that would be not a completed not not incomplete so i might put like 10 percent of it is going to be a completed gift so i go through that materials there too so from one trust to another how do you run the statute of limitations um you would need to get all the beneficiaries of the first trust to um and and to the second trust potentially because there can be gifts back and forth depending on the sale price get all of them to file gift tax returns and if there's an incomplete gift trust then you have those arguments i just mentioned concerned about also the gst statute limitations um isn't going to run until after the later of the tr the transfer or dying or making a distribution to a um a beneficiary a skip person so that's pretty dicey too um so sale from one trust to another is a kind of a challenging thing potentially to get finality on it uh define consideration cause by that i mean and purchase price this is this is my favorite way to do it and not everybody agrees with me and i think it's a judgment call but i like it the best um because we know how much is transferred and those other things with the gift over like if you did a gift over to a spouse or to an incomplete gift trust um then the irs audits so then you have something that's left that you still have to do estate planning with because it's in the spouse's estate or in your state as an incomplete gift trust so so then if after the audit you need to go back and do even more if you do a transfer that i'm transferring all of this and i'm going to pay the purchase price whatever the value is i'm paying it if the irs adjusted higher i'm just going to get more back so that's the philosophy that that i tend to prefer so here's how you do it by 26. um you sell the property for the formula purchase price with a blank in the faith amount of the promissory note you obtain an appraisal and you have an allowance to the note that that's called like in the launch of like an amendment or kind of a supplemental document and that provides the estimated purchase price so i'm selling this for the amount it's finally determined for gift tax purposes appraiser has estimated i use a million dollars so i am estimating that my note is a million dollars um so the appraiser the appraiser appraisal did not determine the million dollar note principle rather it estimated it the determination is when it becomes audited or the statute of limitations runs then it becomes finally determined and then you can wrap everything up and do whatever adjustments are needed to reflect the correct price so we never say the value is x if the irs adjusts on the audit then we change to y that that would lose to procure um so instead the value is finally determined we estimate this x and if i have determined on on audit is y well it always was y because because it's the finally determined amount so anyway that's why my this is my favorite thing to do on slide 28 i just kind of mentioned what i already said so that wraps up that portion so now the next part is um business gifts and alternatives so again the main idea for this is when you sell your business you like to cut in the employees um how do you do it and um and there's other circumstances too that might not necessarily be the sale of business so first let's start off on slide 29 as to when a gift to a service provider is compensation and not a gift so first i'm going to talk about a transfer from an employer compared to a trans to uh to the employee so the company pays the employee versus the transfer from an owner to the employee so you have a corporation if the corporation makes a transfer to the employee versus a shareholder makes it transfer to an employee we're going to talk about that and then we'll talk about a 2020 tax court case um where there was an alleged gift to this from a business associate and and how the tax court came out with that you can probably already tell by the way a phrase that how it came out we'll talk about those um when is a gift compensation not a gift and then we'll talk about whether you just recognize upfront to this compensation and how does that strategy compare to trying to take the position as a gift okay so on to slide thirty um so just starting off from some general fundamentals when you have an employee when you have a business gift you can deduct only 20 up to 25 for the business gift so it's not going to really benefit an employer much to do a business gift in terms of in terms of you know give something up you're not getting a deduction for it so the tax reform act of 1986 said that the income tax exclusion does not apply to any amount transferred by or for an employer to or for the benefit of the employee so the employer gives a holiday bonus at the end of the year and um gives cash out that is compensation and and that's not going to be a gift another example might be the employer pays premiums on policy on an employee is owned by a life insurance trust that the employees set up for the employee's family so that's not the employee doesn't personally get that premium the irrevocable life insurance trust does but nevertheless that's the this that is a trend that seemed to be a transfer from the employer to the employee and then from the employee to the life insurance trust so again the income tax exclusion does not count as um as a income tax exclusive for gifts to not count if the employer is paying the employee with a couple of exceptions i have listed on the slide and the employer is required to report this on form w-2 now in this case it was whether the transfer was hit from the from the employer so we know that that normally a a transfer from an employer to employee is not going to be a gift so that's clear law according to internal revenue code section 102 parentheses c now what about a transfer from a business owner to an employee of the corporation or partnership so in that case it's not a transfer from directly from the employer to the employee but it might be a contribution to capital of the business followed by compensation from the employer to employee so you need to kind of test it is this truly a gift from the owner to the employee or is it the theme contribution to capital and slide 32 so we have a regulation right on point for a corporation it says that we will do this themed contributions and compensation arrangement if the payment is in consideration of services performed by the for the corporation so example so you have the person who owns 100 of the stock of the corporation and there's a king employee and they want to give the key employees some skin of the game so the owner says all right key employee i'm giving you 10 of my shares in the corporation so under that regulation that is going to be considered to be a contribution to capital of those ten thousand shares followed by compensation i mean it was temple about ten percent of shares followed by compensation from the corporation to the employee of that 10 percent now what you would wind up doing is you would wind up grossing up the employee and this grossing up concept we're going to go through in more detail toward the end okay but what if instead um this were a gift for some reason so where do you look for this there's a case called dubristine a 1960 supreme court case and i've got you know all of this materials there but i gave you a quote here it's like 33. um so it's it says against some of the standards um that just because you don't have legal or moral obligations it doesn't mean that it's a gift um and if the if the payments do come from um a constraining force or moral legal duty or some some other incentive then it's not a gift got some more quotations coming on 534 that um if the payment is for services rendered it's irrelevant whether the donor derives economic benefit from it or not so you can see all the language there detached and disinter generosity out of the suction respect admiration charity like impulses those are widely bandied about you'll see those all over the place in this area and um and we we look to see what the transformers intention was um so what was the intention for the payment um but what the proof is uh look on sly 35 535 you don't just look to see what the donor says you do of inquiry as to whether it's really a gift or not so you got to look at the objective facts not just not just what he says she says 536 1983 case where the majority shareholder gave some of their sale proceeds to key employees and gave lesser amounts to retired employees and the minority shareholders did not participate in this so what was the characterization by 37 the majority shareholders felt that they owed it to these t employees to give them some money when they sold the business but um the the tax court said that the employee key employees didn't expect to get anything from the sale and so we're not going to count even though even though the majority employers kind of felt that they had some moral obligation um and in fact there was really no expectation moral legal by the knees as to as to ever getting this money um so um again it says here you know it's a good idea it's nice when the shareholders do do that but again it's not a moral obligation or duty and and you don't want to say that they had a duty because that's just not the law so the irs argued well this was just deferred compensation the employees were under compensated and so now they're paying them to make up for it and but as a matter of fact as a matter of fact there wasn't um so the compensation was fairly done in the past so this is not disguised compensation slide 42 is some of the proof that they were not under compensated by 43. the fact that the majority owners made the gift while the minority owners did not um shows that it was more of a gratuitous thing if there were really some kind of a business reason that business reason benefited both the majority and minority shareholders but the majority shareholders never asked the minority owners to kick in anything um so so the fact that minority orders didn't kick in um helped with the argument that this was truly a gift by the majority shareholders now get this in this case these shareholders said for the experience of their gifts i'm giving you a gift and then they turned around and deducted it on their income tax return so then the court had to kind of talk about that and and they said that even though these guys decided to deduct this thing um that was an improper deduction and you can see on slide 45 some more language from the case that um yeah the fact that they deducted it means means that they thought it was it was compensatory not a gift so these guys wanted to have their ticket needed too they wanted irs to help pay for their for their um gifts but then they didn't want to have the employee taxes on the gift so they want they they had inconsistent treatment and they decided to whip saw the government and and uh basically the court said well even though they just they try to whipsaw the government um we're still not gonna count this as compensation because the um because the the people who received it actually were doneese they it was gratuitous another thing that was important is that that the um the payors um told the donors that they were gifts and didn't have to pay tax and so that does that was kind of consistent with the objective evidence so their intent their subjective intent was not necessarily going to be sufficient but it did corroborate the other evidence in it in that so you can see the ultimate conclusion that this was gifts now let's go on to our 548 our 2020 case and and and again in this case there was payments made to a business colleague and you'll see the amount you'll see the amount soon enough um and the tax court looks at this and looks at duperstein and says that the most important consideration is what the donor's intent is and that um the donor's characterization is not determinative um the court has to make an objective inquiry so so they were basically looking at the old cases and saying yes we got the donor intent it was helpful but it still needed to be corroborated they made the distinction between a common law gift or gift for gift tax purposes or a gift for income tax purposes and so you can see the difference here common law gift is that that the the donor did just any consideration back section 102 gift is more narrowly defined so for income tax purposes for the exclusion that's just a narrower test it has to be detached and disinterested subsidies so from the gift tax purposes give tax purposes we want to make it easy to find a gift so the irs can tax it that was that's theory behind the taxing statute anyway so forgive tech purposes if you make a transfer don't get anything back that's a gift we want to make it easy to tax them on the other hand we don't want to make the exclusion from income tax to be that easy the dhoni needs to be able to prove this detached and disinterested generosity um and you can see here where adoni has many services to a donor payment for services not a gift even if there was no obligation to make the payment um so that's a really key idea there and again in those other cases the services will render to the corporation not to the donor slide 50. so look at the amount involved almost 25 million bucks ultimate issue is whether the taxpayer persuaded the court the transfer totaling almost 25 million dollars constitute the gifts from the payor and the text that the donee has to prove it and if the dhoni does not prove it um then the argument that their gifts doesn't work and there's there's going to be some income so what was the intention of the person who made transfers well in this particular kroner case the transfer was a non-resident alien i think he was like from britain or something like that um but um i remember where he was from but he was a non-resident alien and and there's a lot of deals and the taxpayer didn't want to drag the guy into court so the court said look you know we would really like to know what his intent was i mean you have to have objective proof to back it up or not to back it up but it would be really good to hear from them um we're not going to require you to um to to produce him but you still have to prove it you have to prove his intention so um so go on to slide 52. so what are the taxpayers said they had a business relationship it ended before the tax year um and you got to be buddy buddies according to taxpayers the taxpayer said we were buddy buddies and so so he gave almost 25 million bucks to me and um look at what their tax court said we do not find petitioners and witnesses testimony credible about this close personal relationship um you have not proven that there was anything more than a business relationship where occasionally personal matters were discussed you know the drill you know people like to get friendly but you know people who provide services like to get friendly with people who receive the services and you know people like first of all you just like to get to know the people you're dealing with either on either side of it but just because you get to know somebody you're kind of friendly with them doesn't mean you're willing to give them 25 million bucks that's that's the heart of the course argument so then the question was how did how did the taxpayer try to prove the detached and disintegrated genera generosity is interested in generosity and and they cannot they didn't find any proof um that um that there was something that was the relationship was that close it would justify a 25 million dollar gift you know i'd i'd be happy to take the guy out for dinner if he's gonna give me a 25 million dollar gift um i don't know about you so i hate that 54. it looks like what happened was the transfer orb mr herring acted as a nominee for the taxpayer when they did some deals so there were actually some legal settlements to the taxpayer participating in a particular transaction um and you know when that sale of the business occurred it was all owed by this mr herring guy and um and then mr herring gave 20 i'm going to give 25 million bucks to the uh you know to the taxpayer and the court just said look i don't buy it um it looks like um there were some kind of dealings relating the business that got sold and we're going to you know find that that was not a gift but the bottom line is that the taxpayer failed to meet the burden of proving that it was gifts so something suspicious going on we don't really know we can't really find from that something really evil going on but at the same time the taxpayer has to prove the case taxpayer has not proven the case and therefore the ios wins now on slide 55 yeah we do taxpayer that the fact that you didn't get the guy to testify that we were not going to hold that against you but you didn't provide any corroborating evidence that it was a gift and if you've gotten him to testify maybe he would have convinced us that there was a gift none of the evidence you gave us proved that there was a gift if he got him to testify maybe we would have viewed the evidence differently because maybe his testimony might have persuaded us that he intended there to be a gift and might have let us kind of color the evaluation of the other evidence in a different way than we did but you didn't you get them to testify so we are not persuaded by we're not going to color any evidence you gave us in your favor um we are you know we don't we have no clue what his intention was you didn't prove it but objectively you didn't even get him to testify so too bad all right so that's the standard but you so you can see here that the donee has a burden of proving that it was a gift and the dhoni should probably get the donor to testify and and they they did have testimony of those other cases that mentioned in one way or another directly or indirectly um that the the testimony involving actually the donor himself or herself so we've got a case here where there's some significant risk being taken um because of the the burden of proof that the service provider has to put on but what if you just decide hey we're gonna just own up to it as compensation so um think about it the employer can deduct compensation paid and then the employee would include an income the you know the compensation that was paid but maybe the benefit of the deduction to the employer can allow the employer to do what we call gross up the employee so here's an example bottomless 56 assume a 40 tax rate and you want to get 100 employee 57 if the the employer could could pay um suppose you want to get a hundred dollars cash the employee the employer actually pays 167 cash and includes 167 in income but 57 is paid you take 40 of that that's 67 so 167 cash is paid minus 67 withholding is a hundred dollars cash to the employee so the employee still gets 100 cash you're declaring 167 of compensation in 67 withholding then the employer gets the deduction for that 167 and and gets that same 67 tax savings so effectively what happened is the employer gave a hundred dollars cash to the employee the employer paid 67 dollars worth of withholding but when the employer paid five was tax return it took a deduction and it got a 67 tax benefit for that deduction so the employer was really not out of pocket anything more than 100 bucks that's the theory behind this idea now the idea kind of breaks down a little bit and that the employer and employee need to pay fica tax on compensation and also what if the employee employer are not in the same tax bracket and um one issue which i've seen happen before is that if the payment is very large the deduction might very well push the employer into a lower tax bracket and the employee into a higher tax bracket and that wouldn't be good at all and and here's where that really happened on 559 if the employer is taxed at capital gain rates capital gain rates are significantly lower than ordinary income but if the bottom line is that the employer already has enough deductions to offset ordinary income and then really all that's happening is the capital gain rates on the sale of the business and then they pay when they have a deduction for the compensation paid to the employee um yeah that's an ordinary deduction but all they have left is capital gain that they're offsetting with it so even though it's an ordinary deduction um the only income that's being offset is capital gains so their tax their their tax savings is that capital gain rates so the deduction is worth less so it's being deducted at capital gain rates while the employee is reporting ordinary income so this kind of breaks down um also note that there's payroll taxes on it and and so the payroll taxes increase the cost to everybody so you may get some kind of an offset through the compensation it's probably not going to be perfect but consider the alternative what if it's a gift instead of compensation well if the donor has lots of exemption out the wazoo um then yeah a gift is good but if the donor is a taxable estate you consider about a 40 tax savings you know that may be out of pocket that whole 40 percent estate tax cost so so you have the 40 state tax costs without any offsetting deduction yeah it's deferred many years in the future but how does that forty percent many years in the future compared to this offset that i just described with the income and versus expense in many cases the compensation is still more worthwhile um so i kind of go through other ideas and slide i'm going to leave those to you to to look at because i'm nearing the end of the time here um i don't really have any questions that i've received but i've had some comments made um but um let me just uh flip on over here uh by the way here's the the the comments i had was a comment about um the timing of a fight is elected when when the law might change and also there are reasons why diarrhea backwards the core decision so that point was made you can think about it on your own um so um everything that i said here again in this one and a half hour brief overview each segment is going to have an hour to an hour and a half with with a free course on lecturing for cpa academy um and you get not only cle but also cpe credit so for those of you who are accountants or if you have any content people who 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