For all of our existence, one common misconception among the general public was that estate planning was only for rich people and “Trust Fund Babies”. However, this notion could not be further away from the truth, especially when considering the recent changes we have seen in family dynamics and financial opportunities.
The three major financial institutions of the United States consist of the banking industry, stock brokerage industry, and insurance industry. Under the Glass-Steagall Act, each major industry could not engage in activities that fell within the scope of the other two industries. In 1999, the Glass-Steagall Act was repealed and the door was left open for each major industry to conduct activities and transactions that fell within the scope of the other two industries. This in turn increased the probability for both unlimited prosperity and financial collapse.
The second part of this two-part article analyzes financial planning from an estate planning standpoint. Financial planning is an essential component of estate planning. The amount of wealth you generate prior to retiring will generally determine whether you will have a comfortable retirement and have anything left over to pass on to your descendants after your death. When choosing a retirement plan, you ideally want some combination of the following tax efficient strategies: for the contributions to be tax deductible, the appreciation to be tax deferred, and the distributions to be tax-free.
Life expectancy for both males and females in the United States has been on a consistent rise since the 1900s. At the turn of the 20th century, the average man and woman did not live past the age of 50. At the turn of the 21st century, the average man lived up to the age of 75, while the average woman lived up to the age of 80.
This data is significant for several reasons. First, since the age of retirement is currently at 65, the average man has to live at least ten more years after retiring without earning any income, while the average woman must live for an additional 15 years without earning any income. Second, living longer may inevitably cause for more people to opt out to work beyond the age of 65, since it is likely that most people would not have secured enough financial resources for a comfortable retirement when they reached the age of 65. Third, federal programs for retirees, such as Social Security and Medicare would now have to presumably be subjected to cuts, since there would now be significantly more people utilizing the resources of these federal programs due to the spike in life expectancy.
Living comfortably during retirement does not include only the necessities one needs to survive, but also includes engaging in activities that derive pleasure. However, the necessities alone can have a hefty price. If you think about the expenses you will have for your housing needs that may include rent, mortgage, insurance, or property tax, then add those expenses to groceries and hygiene products, these expenses alone can be costly. In addition, you will probably need to get from your home to a supermarket or another point of destination by car, train, bus, or other form of transportation. Since most people in California use vehicles as their preferred method of transportation, the fluctuating price of gas, insurance, and car payments may add on yet another set of expenses that may be unsustainable at the time of retirement.
The expenses don’t just end there. One of biggest expenditures during retirement pertains to health care. While Medicare covers some of those expenses, it may not cover them all. Thus, regular checkups even for the healthiest individuals, combined with pharmaceutical drugs and other related products can also be very expensive. If you also add outstanding loans in the mix, such as credit card and student loan debt, the monthly expenses may not even be sustainable for a middle-income earner, let alone a retiree who no longer earns income.
Besides the necessary expenses, there are also expenses associated with leisure. When people are asked about their vision for retirement, some say they plan on traveling at least once a year, some say playing golf and tennis several times a month, others say dining with their spouses at a local restaurant every weekend. Needless to say, all of these activities may cost a considerable amount of money, and in some cases, a significant amount of money.
From the retirees’ standpoint, many of them have been looking forward to retirement by working hard in their prime years. Thus, their aspirations for retirement are warranted in many instances. However, when they approach retirement, many of them realize that they do not have sufficient funds to comfortably enjoy their retirement years.
Foundational Financial Concepts
There are two foundational concepts related to finance to keep in mind as you are going through this article. The first concept is whether the income you are generating comes from an active or a passive source. The second concept is whether your money will grow or diminish in value as you approach retirement.
Active income pertains to any source of income where your active involvement will be required in order for the income to be generated. One such example of active income is your salary. Passive income pertains to any source of income where your active involvement will not be required in order for the income to be generated. One such example of passive income is investment income from real estate. The fundamental issue upon retirement is that nearly all of the income you receive must be predominantly derived from a passive source since you will no longer be working to earn a living.
Passive income will be a significant factor in determining the quality of life you will have when you retire. It follows that it is critical to invest in places that will provide an adequate return on your investment. Hence, how much return you will have on your money is a necessary element in determining to what extent your money will grow before you retire. One of the essential indicators that will determine to what extent your money will grow or diminish in value is inflation.
The underlying concept behind inflation is that every time new money is printed by the government, the value of your existing dollar diminishes. No retirement plan is complete unless it factors in inflation. The rate of inflation averages at approximately 3% per year. Thus, if you have $5,000 in your retirement portfolio today and you retire in 20 years, you will need $9,030 to match the purchasing power of today’s value of $5,000.
Depending on your financial goals, there are various avenues available for stockpiling your money. The primary considerations in picking the avenue that is best for you will depend on how much of a return you want on your money and how much control you want to have over your money. Generally, the more control you have over your money, the less of a return you will have on your money. The opposite is also generally true.
Between the three major financial institutions (Banking, Stock Brokerage, and Insurance), there is no shortage of places for putting your money. Some examples include Bank Accounts, Certificate of Deposits (“CD”), Money Market Accounts (“MMA”), Savings and Loans, Credit Unions, Stocks, Bonds, Mutual Funds, Exchange Traded Funds, Annuities, and Life Insurance. A retirement portfolio should generally be diversified to include a combination of several avenues with a special outlook for inflation, taxes, and fees that may be associated with the maintenance and withdrawal of your money.
When you put your money in an Individual Retirement Account (“IRA”), you will generally pay a 10% penalty if you withdraw your money before you are 59½ years old. On the contrary, when you put your money in a Bank Account, you generally have unfettered access to your money. As such, Bank Accounts provide the lowest return on your investment, generally at 0.01 percent. CDs and MMAs generally provide less than a one percent return on your investment. Stocks and Bonds may provide significantly larger returns, but they are subject to volatility and other market risks.
Economic conditions determine not only the overall strength of the economy, but they also have a significant impact on inflation (or deflation), interest rates, and volatility. One of the primary methods for measuring the strength of the economy is the stock market. While the stock market has historically performed well, it has also crashed many times in the last 100 years, most notably in 1929 and 2008. In both instances, the U.S. economy went into a severe recessionary period.
In 2008, the stock market crashed primarily due to the collapse of the housing market. Millions of people lost their jobs and witnessed their 401(k) accounts plummet. The government paid trillions of dollars to businesses and banks. In order to prevent a complete collapse of the economy to the point where ATMs were at the verge of becoming inoperative, the Bush administration paid $700 billion to the major banks. Needless to say, the financial crisis of 2008 caused a severe panic on Wall Street, Main Street, and virtually everywhere else in the United States.
The viability of the stock market is an important consideration for an investor since it generally determines how much activity there is in the economy. During a recessionary period, people generally do not invest in the stock market. In addition, as we saw in 2008, the government printed a significant amount of extra money in case the recession led to a depression. When the recession was over, all of the extra money started circulating in the economy, thereby causing inflation. Thus, not only did many people lose a significant amount of money, but any money they had left was now worth less in value than before the crisis began.
In 1935, the social security program was authorized with the passage of the Social Security Act of 1935. The social security program grants benefits to people who reach the age of 65. The program is contributory, where both the employee and employer contribute to the program. Pursuant to the Federal Insurance Contributions Act (“FICA”), the social security program requires for 6.2% of the employee’s income to be paid by the employee and 6.2% to be paid by the employer (capped at $110,000 per year or $2,500 per month).
At the time the law was passed in 1935, the average life expectancy was at age 63. Today, the average life expectancy is nearly at 80. In all likelihood, there will come a point within the next decade where the age of retirement will be raised by at least two to three years to as much as five years. Another likely outcome is that the amount of the benefits received will also be reduced due to longevity and an increase in the population size. In 1935, the U.S. population size was 127.3 million, today it has 325.7 million inhabitants. Therefore, it is not realistic to expect that the social security benefits we will be receiving in the near future will remain at their current form.
Defined Benefit Plans
In addition to the federal social security program, the retiree may also be entitled to receive income from state-funded programs such as public pension plans. Similar to social security, pension plans provide for guaranteed income for life. Pension plans for both public and private employees are Defined Benefit Plans. The income that will be derived from a pension plan is known in advance, hence, the amount is defined.
Most public pension plans across the United States require for the employee to contribute generally between seven to nine percent of his or her gross salary. The same percentage is generally also matched by the employer. Today, pension plans are predominantly available to only government employees. California has over $333 billion in unfunded pension liabilities according to some estimates. California has also seen a significant increase in its population size, which also suggests that California is likely going to implement severe cuts in its pension programs in the near future.
In the private sector, there are significantly less employers who provide pension plans to their employees primarily because of the employers’ exposure to potential liability. The employers have complete oversight over the plans, including funding future benefits and paying fees and expenses associated with the plans. The funding of future benefits became especially burdensome when Congress passed the Employee Retirement Income Security Act of 1974 (“ERISA”), which required for the employers to maintain enough money in a trust to pay for their employees’ future retirement benefits.
Defined Contribution Plans
As opposed to a Defined Benefit Plan where the amount that will be received upon retirement is defined, the money that is put in a Defined Contribution Plan is defined. One of the most famous and infamous types of Defined Contribution Plans are 401(k) plans. The 401(k) plans generally allow for the employee to contribute approximately seven percent of his or her gross salary and for the employer to match the first 3 percent of the contributed amount. The 401(k) plans are popular because they allow for the amount of the contribution to be tax deferred until the withdrawal period. However, as illustrated below, one major downside to a 401(k) plan is its dependence on market volatility since most 401(k) plans invest in a spread of mutual funds, including stocks, bonds, and money market investments.
Let’s assume that a particular 401(k) plan has $1 million. In the first year, the market had a 30 percent increase, which brought the total amount in the account to $1,300,000. In the second year, the market has a 30 percent loss and the plan is now worth $910,000. Even though in both years there was either a 30 percent gain or a 30 percent loss, the net amount is $90,000 less than the initial amount of the investment. During the 2008 recession, it is estimated that 401(k) plans lost between 25 to 50 percent of their value due to their dependence on market risks and volatility.
Under Treas. Reg. §1.401(a)(4)-(9)(a), a person is permitted to combine one or more Defined Benefit Plans with one or more Defined Contribution Plans. The combination plans are popular particularly among small business owners, especially where the business owner is also an employee of the business. In addition to providing for financial security in retirement, these plans provide for an opportunity to shift large amounts of income thereby reducing the tax liability of the taxpayer.
Similar to social security and pension plans, annuities may also provide guaranteed income for life. Annuities are based on mortality credits. In other words, the longer you live, the more benefit you may receive. There are two overarching categories of annuities: Immediate Annuities and Deferred Annuities.
Immediate Annuities can either be for a specified period of time or for a lifetime. The way it generally works is that a person pays a lump sum to an insurance company and in return receives income for either a specified period of time or for life. If you enter a contract for a Deferred Annuity, you may pay a lump sum or make a series of payments to the insurance company and your money will start earning interest without any tax obligations until distributions are made.
There are two types of Deferred Annuities: Fixed Deferred Annuities (“Fixed Annuities”) and Variable Deferred Annuities (“Variable Annuities”). Fixed Annuities provide a fixed return on earned interest, thus it operates like a CD, but generally provides a larger return on your investment. However, unlike a CD where taxes are due on the interest earned each year, taxes are not due for Fixed Annuities until withdrawals are made. Variable Annuities also allow for the taxes earned on the interest to be deferred, but they are subject to market risk and volatility. On the other hand, Fixed Annuities are not subject to market volatility.
Variable Annuities provide guaranteed death benefits, which adds a layer of protection in the event that the value of your annuity is less than your initial investment. However, unlike a death benefit in a life insurance policy, the death benefit under an annuity may not be entirely tax-free. Fixed Annuities also provide significant benefits, such as allowing a family member to be a recipient of the annuity in case the annuitant dies before exhausting the period of the annuity. For example, you are guaranteed to receive $50,000 annually for 25 years. If you die before the 25-year period, your spouse will receive $50,000 until the end of the 25-year period.
When the insurance company writes a life insurance policy, the risk is that the insured will die soon, thereby causing a payout that is much larger than the investment. On the other hand, the risk with an annuity is that the annuitant may live long, thereby granting lifetime income in an amount that is much larger than the initial investment. There are two overarching categories of life insurance policies: Term and Permanent.
Term policies are usually between one to twenty years. The premiums for Term policies are generally lower in the beginning, but they tend to rise quickly to the point that it becomes unaffordable to maintain the policies. Permanent policies are generally in two forms: Whole Life and Universal Life.
Whole Life policies generally guarantee that the premium will stay the same and that it will never increase in addition to guaranteeing a death benefit and cash value. Universal Life policies are permanent policies that consist of a combination of low premiums that are available in term policies and tax deferred guaranteed interest fixed accounts.
Prior to purchasing an annuity or life insurance policy, it is important to consider whether Long-Term Care (“LTC”) can be included as a hybrid policy or whether a separate LTC policy should be purchased altogether. LTC is a type of care that a person requires as a result of his or her physical condition in order to engage in basic daily activities.
The activities that fall within the scope of LTC include dressing, bathing, and going to the bathroom. Since such care may be required for the entire duration of all waking hours, these services can be very expensive. Even though Medicare and Medicaid may provide for as much as 50 percent of the cost of those services, there should also be other funding sources since the annual expenses for LTC can be as much as $100,000. An LTC policy may pay for home care, hospice care, nursing facility, or assisted living facility. The policy may potentially apply to a family member if the policy is never exercised by the insured.
Important Note: Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance on its use. Additionally, certain changes in law may affect the legality of the information provided above and certain circumstances of the reader may vary the applicability of the above content to his or her situation.
For all of our existence, one common misconception among the general public was that estate planning was only for rich people and “Trust Fund Babies”. However, this notion could not be further away from the truth, especially when considering the recent changes we have seen in family dynamics and financial opportunities.
Families have historically been composed of one male parent, one female parent, and one child (or children). While traditional families are still very much in existence, there are now compositions of family structures of virtually every imaginable scenario. This includes families with children raised by single mothers or single fathers, cohabiting couples with or without children, and people who neither have children nor cohabiting partners. By no means is this an exhaustive list. Therefore, the internal makeup of virtually every household is unique, which in turn requires carefully crafted planning techniques to be implemented for each individual family.
The first part of this two-part article analyzes planning considerations for families with young children, families with adult children, married couples, unmarried cohabiting couples, and people who neither have children nor cohabiting partners.
Families with Young Children
Families that have children who are under the age of legal consent or with special needs should consider particular planning strategies for their children. One critical decision in either instance is choosing the right guardian for the child in the event the parent is incapacitated or dies. If there is more than one parent, the first potential dispute that may come up between the couple is whether the guardian will be with the relative of either parent. This decision may inevitably lead to some tension as one parent might believe that his or her relative is better positioned to raise the child than the other parent’s relative. For children with special needs, one additional consideration is whether the child will lose government benefits if he or she inherits any assets.
Families with Adult Children
When analyzing planning strategies for families with adult children, the issues that are particular to the adult child and the issues that are particular to the parent are equally important to consider. From the parent’s standpoint, one problem to anticipate is elder abuse. If a person becomes physically or mentally incapacitated due to old age, it is common in such instances for him to be taken advantage of from people both outside and inside of his family.
Another major consideration from the parent’s standpoint is whether he is adequately prepared to deal with the various problems that may inevitably arise with old age. For example, whether he has determined in advance the degree of assistance he will need from caretakers and medical practitioners if he ends up with a certain disease or disability. Another issue to consider is what type of government benefits he may receive and whether such benefits are going to cause him to lose his personal assets in order to hold on to the benefits. Yet another consideration is whether some planning strategies can be implemented to transfer those assets to the next generation or protect those assets by various planning tools.
From the adult child’s standpoint, there are also many issues to be resolved in advance including to what extent she is going to be involved in her parent’s daily activities; whether her parent will live with her or in a retirement home. Another consideration is whether the child also has children of her own and how the existence of her own children might have an impact on the level of financial and emotional commitment the adult child may have for her aging parent.
Many of the considerations for married couples are beyond the scope of this article. Nonetheless, every married couple, just like every individual, has characteristics that are peculiar to that couple. However, some common considerations for all married couples from an estate planning standpoint include the length of marriage, prior marriages (if any), children (if any), children from prior marriages (if any), age of the children; the couple’s age, health condition, financial status, financial goals, estate tax and other tax considerations.
Planning for married couples becomes even more important when there are other marriages factored in that had been formed before or after the death of the first spouse. In the event a person dies and he or she is married at the time of death, two critical inquiries should be immediately sought to be ascertained. The first inquiry is whether any planning techniques were implemented prior to the death of the first spouse. If no planning techniques were implemented, then the distribution of the decedent’s estate is probably going to be determined by the courts. The second inquiry pertains to the process that is going to be implemented immediately after the death of the first spouse.
The story of Humphrey and Whitney as depicted below demonstrates the potential chain of events that may be set in motion after one of the spouses dies. In order to follow the story more effectively, it is worthwhile to provide some background facts. In this hypothetical, Humphrey was married and had children prior to his marriage with Whitney. Later, Humphrey died and Whitney remarried.
Humphrey and Whitney had three children. Humphrey also had two children from his prior marriage. Humphrey and Whitney met with an estate planning attorney who asked Humphrey how much control he wanted Whitney to have over his assets in the event that he died before Whitney. The attorney also asked whether it was important for Humphrey to provide financial security for his two children from his prior marriage once he was dead.
Humphrey died five years after implementing his estate plan. After three years from his death, Whitney remarried and had one child with her new husband. Prior to his death, Humphrey instructed his attorney to put provisions in his trust instrument that would effectively provide for all five of his children from his estate after his death. Humphrey was concerned that if he died before Whitney and Whitney remarried or incurred debt, some or all of his assets might have fallen into the hands of Whitney’s future spouse or they would have been exposed to creditors, bankruptcies, or lawsuits.
In order to avoid all of the potential pitfalls and protect all five of his children, Humphrey designed a plan that met this end. Upon Humphrey’s death, all of his assets were transferred to an irrevocable trust, where all five of his children and Whitney were the beneficiaries. Other than receiving income from the trust assets that was necessary for her health, education, and support, Whitney did not have any other interest in the trust. For example, she could not take Humphrey’s assets and give them to her own children, including the child she had when she remarried after Humphrey’s death. As a result, Humphrey’s trust protected all five of his children, including his two children from his prior marriage to Whitney.
Humphrey was also concerned that all five of his children were too young to manage his assets, which were worth a considerable amount. He was afraid that some of his children might turn to substance abuse or become accustomed to other potentially harmful lifestyles due to having access to large sums of money. Hence, he enacted provisions in the trust to ensure that his children were provided for throughout their lives and that the trust was managed by a trustee who had the competency to grow the trust assets and preserve them not only for his children, but for any of his grandchildren that might be born in the future. He also included a provision in the trust which allowed his children to manage the trust assets along with the trustee after reaching a certain age and specific level of sophistication.
In some instances, couples who cohabitate have no intention of ever getting married. There may be several reasons for such an approach. For example, one of the partners may be wealthy and is afraid of losing a portion of his wealth if the marriage is ultimately unsuccessful. Another example is that the marriage may not be beneficial from a financial standpoint such as tax efficiency.
In other instances, it may be more beneficial for a cohabiting couple to register as domestic partners or form cohabitation agreements. As an example, California provides many of the same benefits to domestic partners that it provides to married couples. However, not every couple in California can qualify to be treated as domestic partners.
For couples who do not qualify for the domestic partnership treatment, a cohabitation agreement should be considered especially if one of the partners is regularly paying for items that benefits both partners (e.g., mortgage payments). These agreements set expectations regarding the rights and obligations of each party. Cohabitation agreements are also a better source for conflict resolution in the event the couple has a dispute, falling out, or if one of the partners dies.
Even though most cohabiting couples remain as such or end up single, a significant portion of cohabiting partners eventually end up marrying each other. If a marriage is contemplated, the predominant considerations prior to marriage should include prenuptial agreements. As opposed to postnuptial agreements that are executed after the marriage has gone into effect, a prenuptial agreement is a contract that is executed before marriage. This agreement determines how the assets will be divided in the event of a legal separation or divorce.
A prenuptial agreement has historically been frowned upon by the public. Society and our general thought process lead us to believe that if a prenuptial agreement is formed, then we are intending to lose the war before we ever set foot on the battlefield. In other words, we are contemplating a divorce before the marriage even begins. However, this notion is arguably misleading and it is not in accordance with the modern way of life.
There are many reasons for which a prenuptial agreement should be considered. As of 2018, the divorce rate in the United States is as much as 50 percent (depending on the demographic group). Even though some newlyweds have beautiful love stories, the life span of the marriage of such newlyweds is arguably still a toss-up. Therefore, it would be wise to have a plan in place prior to the marriage that will delineate how the married couple’s assets will be distributed in the event of a divorce, as opposed to leaving such decisions in the hands of the courts.
In addition to prenuptial agreements, formalities must be followed to ensure that any property that is designated as separate property prior to the marriage is not only titled as such, but also to ensure that such property is not commingled with any of the assets of the community. This is especially important for couples residing in California, since California presumes that any property acquired after the formation of the marriage is community property.
In a community property state such as California, all assets and liabilities that have been acquired or incurred during the duration of the marriage are generally equally apportioned to each spouse. This standard invites creditors and predators of either spouse to potentially access the assets of the spouse who has not committed any wrongdoing. If there are also children involved, then there may be little financial protection for the non-debtor spouse and his children.
It may also be the case that the debtor spouse herself did not commit any wrong. She was simply in a risky line of business or she was found liable for the wrongdoing of her employee. Moreover, if she later files for bankruptcy, the non-debtor spouse’s assets may also be within the creditors’ reach. This may be true even if the assets are titled only in the non-debtor spouse’s name.
People without Children, Parents, or Cohabiting Partners
In the last decade, the amount of people who remain married has been steadily descending to the 50 percent zone. In other words, almost half of the population of the United States is either divorced, widowed, or has never been married. However, this does not mean that those who are not married are necessarily single. Many of them are either cohabitating, dating or in serious relationships. People who fall in these categories should also entertain the possibility of executing prenuptial agreements if a marriage is contemplated.
There are arguably many benefits to being married, including physical, emotional, and financial support. From a financial standpoint, the household itself generally ends up having more money than a single person would on her own. In addition, people who file taxes as married couples generally pay taxes at lower rates than single filers, cohabiting couples, or married couples who file separate tax returns.
For everyone, probably more so for single people, the primary concerns for the long-term are who will take care of them once they reach an age or condition where they can no longer care for themselves; who will make health care and financial decisions on their behalf when they can no longer make those decisions for themselves; and who will inherit what they leave behind. It follows that estate planning is as equally important for decisions that are made during a course of a person’s life as well as the legacy the person will leave behind upon death.
Important Note: The story of Humphrey and Whitney is a work of fiction and the product of the author’s imagination. Any resemblance to actual persons, living or dead, or actual events is purely coincidental. Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance on its use. Additionally, certain changes in law may affect the legality of the information provided above and certain circumstances of the reader may vary the applicability of the above content to his or her situation.
Let’s begin by debunking an age-old myth that somehow estate planning is only pertinent to those people who have a significant amount of wealth. There are many compelling reasons for anyone to have an estate plan. One such reason is to prevent the courts from making decisions on your behalf, especially in such a manner that you would probably not want to be made in the first place. In addition to overriding your wishes, the court proceedings may come with a heavy price tag and take a very long time before all the dust settles.
In essence, effective estate planning solves matters of life and death. It allows you to decide who will make health care and financial decisions in the event a mental or physical condition renders you disabled or incapacitated. It also allows you to determine who will inherit your assets and when those assets will be inherited. Similarly, estate planning allows you to determine who will inherit your business in the event you are disabled, incapacitated or dead. It also provides you with the tools you need to protect your children and any family members with special needs.
In today’s world of advance science and medicine, estate planning is evermore essential since people live longer now than in recorded history. Consequently, living longer makes us more susceptible to suffering from complicated illnesses or diseases. The more complicated the condition, the more resources it may take to battle that condition. Additionally, onset and progression of some medical conditions may be acute and rapidly progressive. We have all heard stories of someone in good health tragically passing away within a month of a sudden diagnosis of a terminal illness.
There are also events that occur purely by happenstance. Someone may cross the street in break daylight and get run over by a car. For the rest of his life, the pedestrian is stuck to a wheelchair and his family is forced to find some ways to offset the emotional, physical, financial, and social implications of his disability. To make matters worse, the family may now have to prove to the courts that they should be granted with the authority to make all of the health care and financial decisions on behalf of their disabled family member.
When that family member dies, they may now have to prove to the courts that the decedent intended to pass everything he owned to them after his death. This of course creates an opportunity for predators to intervene in the court proceedings in order to obtain some portion of the estate. Another common downfall in this context is family disputes.
It may be that one family member feels more of an entitlement to the estate than the other. So now, two siblings are set to duel in court to determine who gets the fair share. Of course, each thinks that he or she is entitled to a greater share. One of them claims she should get more of the estate because she was the one who took care of the dying parent, while her brother claims he should get more because he was the one who arranged all of the finances, which resulted in a substantial increase in the value of the estate.
Perhaps the best way to illustrate what set of disasters lack of planning may lead to is to share Eli’s and Vicky’s stories. Eli was a 75-year-old man who suffered from a terminal illness. His niece was a criminal defense attorney, who has been encouraging her uncle to engage in proper estate planning for several years. Eli was a man of modest means and he did not believe he would ever need an estate plan.
Ever since Eli was diagnosed with his terminal illness, his family has suffered tremendous hardships, including conservatorship, because Eli did not have an estate plan that addressed the matters related to his health and finances in advance. While he eventually understood the value of estate planning as a result of these hardships, the last thing Eli wanted to think about while he was in his deathbed was consulting with an attorney who would craft a plan according to his wishes. As a man of faith, Eli firmly believed that he was going to defeat his terminal illness. Therefore, he decided to postpone the design and implementation of his estate plan until he was cured of his illness.
On a beautiful sunny Sunday afternoon, Eli started experiencing chest pains, which quickly progressed to a heart attack. His wife of 45 years bursted into tears as she felt that she was about to lose the only man she ever loved. After taking several deep breaths, she called 911. Ten minutes after her call, the paramedics arrived. Upon arrival, they realized that if they did not get Eli to the hospital immediately, he would die.
While the paramedics were rushing Eli to the hospital, Vicky was in her car grooving to her favorite song, “Hit the Road Jack”. As she approached the middle of the intersection, the paramedics ran the red light and crashed into her coupe. The paramedics ran some tests and realized that Vicky was also facing death. Another emergency vehicle arrived at the scene and took both Eli and Vicky to the hospital.
Shortly after arriving at the hospital, Vicky fell into a coma, which eventually led to her being on life support. Since the hospital was not in possession of any relevant documents, the doctors began searching for Vicky’s next of kin in order to determine whether Vicky should remain on life support. Unfortunately, Vicky did not have documents that revealed who might have authority to make health care decisions on her behalf, especially decisions that dealt with end-of-life matters.
At the time of her hospitalization, Vicky’s only living relatives were her two young boys and her cousin Connie who lived in Boston. Connie immediately petitioned with the court to become Vicky’s conservator in order to have the authority on the decision of life support on Vicky’s behalf. Even though Connie had to spend $2,000 on the proceeding, she was eventually appointed as Vicky’s conservator.
Over the next few days, there was an intense debate between Connie and Vicky’s friends on whether they should take Vicky off life support. Following the debate, Connie decided to turn off Vicky’s life support, which led to Vicky’s death. Vicky was 38 years old at the time of her death. Upon her death, the only significant asset she owned was a 50% interest in a hair salon, which was worth $350,000.
Shortly after Vicky died, the police were forced to take her children into protective custody and place them in foster care. No documentation was provided that would establish who would be the legal guardian of the children in the event of Vicky’s death. This was the case not only until the custody hearings concluded, but also after their conclusion. Thus, the children were to remain in foster care until the court determined the legal guardianship and custody status of the children.
In the meantime, Vicky’s best friend Franny tried to convince the authorities to allow the boys to stay with her until the custody hearings concluded. However, the authorities could not honor her request because she did not have the legal authority to look after the boys. Even though Connie arrived in Los Angeles from Boston shortly after Vicky’s hospitalization, she also did not have the legal authority to look after the boys.
The terrible situation the boys were placed in was beyond imagination. Not only did they just lose the only person they relied on for emotional and financial support, but they now had to live in uncomfortable circumstances with complete strangers. In the midst of all the hardship, they were constantly being dragged into court for the hearings.
There were two separate hearings that were set to take place following Vicky’s death. The probate proceeding would determine who was going to inherit Vicky’s assets. The custody proceeding would determine who was going to raise Vicky’s children.
Vicky’s ex-boyfriend and the father of her two sons, Doug, intervened in both hearings after learning of Vicky’s net worth. The custody battle ensued between Doug and Connie. During the hearings, Doug met his two boys for the first time in over ten years. Even though Vicky and Connie had a falling out over the years, Vicky told many of her friends that if something happened to her, she wanted Connie to raise her children; especially since Doug was a drug addict and she did not trust him with the responsibility of raising her children. However, she did not effectuate her wishes in a legally enforceable document.
The probate proceeding was not a smooth process either, especially since Vicky’s business partner, Pat, was also faced with a dilemma. Pat is a savvy businessman who owned 50% of the hair salon that Vicky operated. Pat provided the initial funding for the business, but he was a passive investor and he did not want to get involved in the day-to-day operations of the hair salon. He also did not have any experience with cutting hair.
Despite being a savvy businessman, it never crossed Pat’s mind to form a succession plan with Vicky that would solve substantial issues including how the business would be impacted in the event that either he or Vicky became disabled, incapacitated or died. As such, the probate proceeding would ultimately determine who would inherit Vicky’s interest in the business. During the proceeding, the court appointed the personal representative of Vicky’s estate. The primary role of the personal representative was to negotiate with Pat in order to determine the best strategy for the business going forward.
If there were any previous agreements or other relevant legally enforceable documents available, not only would the issue of succession planning be solved without interference from the court, but also the transfer of Vicky’s interest in the business to her heirs would likely not have been determined by the court. As the hearings were taking place, the business was not making any money. Due to the urgent nature of the transaction, Pat and the personal representative sold the business to a nationwide chain of hair salons for a price far below its market value.
Approximately fifteen months after Vicky’s death, all of the hearings concluded. The total legal and other related fees amounted to $35,000. Doug was awarded full custody of the boys. Both hearings determined that Doug and Vicky had a putative marriage. In other words, there was ample evidence supporting Doug’s claim that he believed in good faith that they were married, but there was a legal impediment which prevented their marriage from being recognized by the law. As such, the probate court granted Doug with nearly everything Vicky owned at the time of her death, while Connie received nothing.
At around the same time Vicky’s estate was settled, Eli had another stroke. While he was recovering at the hospital, a doctor informed him of a new treatment that has been shown to treat Eli’s illness. Even though the treatment has been effective on only one-tenth of the tested subjects, the doctor believed it may work on Eli since the subjects with a similar blood type as Eli have shown positive results at almost 90% of the time.
Fortunately for Eli, the treatment worked and he was cured of his illness. Even though his conviction in his faith paid off, he learned a valuable lesson. He recognized that all of the uncertainty that his wife, children and grandchildren faced when he was battling with his illness compounded the pain they felt while they were witnessing his suffering. After truly appreciating the hardships his family endured, his first act after leaving the hospital was to schedule an appointment with one of the leading attorneys in estate planning to help him craft his estate plan and pass on his legacy to his future generations.
Important Note: The stories of Eli and Vicky are a work of fiction. Names, characters, businesses, places, events, locales, and incidents are either the products of the author’s imagination or used in a fictitious manner. Any resemblance to actual persons, living or dead, or actual events is purely coincidental. Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance on its use. Additionally, certain changes in law may affect the legality of the information provided above and certain circumstances of the reader may vary the applicability of the above content to his or her situation.Read More
Under the new tax laws (“TCJA”), there is a new deduction available to owners of pass-through entities. Section 199A of the Internal Revenue Code allows owners of pass-through entities to deduct up to 20% of their business income from their income taxes. The first portion of this article provides an overview on the various types of pass-through entities that are included under Section 199A. The second portion of the article provides an analysis on the conditions that the owners of pass-through entities must satisfy in order to qualify for the 199A deduction.
For purposes of Section 199A, the following entities are entitled to the deduction: sole proprietorships, partnerships, limited liability companies, S corporations, trusts, and estates. The most distinguishing characteristic of pass-through entities is that the entities themselves generally do not pay tax. Instead, all of the earnings and expenses are passed through to the owners who pay the taxes on their individual tax returns. The sections below provide an overview on the general characteristics of each type of pass-through entity.
A sole proprietorship is not a separate entity from the business owner. It is operated by a specific individual. All benefits and obligations alike are limited to only the business owner. It cannot be passed to a different person unless the new owner creates a different sole proprietorship or a different type of business entity. Even if the business has employees, the risks and liabilities of the business are assumed only by the single individual.
Sole proprietors often receive Forms 1099-MISC during the course of their business dealings, which they must report along with their other income. The income and expenses pass through to the business owner and they are reported on the individual’s personal tax return on Schedule C (or Schedule C-EZ) of Form 1040. If the sole proprietor accumulates net earnings of $400 or more from his self-employment, he must pay self-employment tax by filing Schedule SE with his Form 1040.
A partnership is generally a business venture between two or more persons who agree to carry on a trade or business. In essence, it is a contractual relationship, which can be written or oral. Each partner contributes money, property, or labor in return for a share in the profits and losses of the business. The rights and responsibilities of the partners are generally included in the Partnership Agreement.
Partners owe fiduciary duties to each other and to the partnership. These duties include the duty of loyalty, care, and the duty to act in good faith. A partner may legally bind the partnership provided that she has authority to engage in a particular course of conduct on behalf of the partnership. Authority is generally presumed if the transaction was part of the usual and ordinary course of the partnership’s business operations.
For federal tax compliance purposes, a partnership must report the income, deductions, gains, and losses from its business operations on Form 1065, but the partnership itself generally does not pay tax on its income. However, the partnership must issue Schedule K-1 to each partner. The partner’s share of partnership income is reported on Schedule E.
In a General Partnership (“GP”), all partners are jointly and severally liable for the debts and obligations of the partnerships. For example, if a partnership has two partners and it defaults on a loan, each partner may be personally obligated to satisfy the balance on the loan. Similar to sole proprietorships, this factor is problematic from asset protection standpoint because it does not protect the business owner’s assets from the risks that may arise during the course of business operations.
A Limited Partnership (“LP”) is a two-tiered partnership entity with at least one general partner and one limited partner. In California, the Partnership Agreement must be in writing and the Certificate of Limited Partnership must be filed with the Secretary of State of California. The general partner legally binds the partnership for any decision she may make throughout the duration of the partnership. She is also liable for all the debts of the LP. On the other hand, a limited partner will generally not be subject to liability unless he loses the protection of limited liability for various reasons, such as when he actively participates in the management of the partnership.
In California, a Limited Liability Partnership (“LLP”) is restricted to only certain class of professionals such as lawyers and accountants. The underlying purpose of an LLP is to avoid liability on the members of the partnership for the malpractice of their partners. For instance, if the law firm is an LP instead of an LLP, all of the attorneys who participate in the management of the law firm may be jointly and severally liable for the malpractice of their partners. Since California forbids law firms from forming LLCs, the law firm may in the alternative incorporate. However, corporate formalities can be much more complex than the management of a partnership under a Partnership Agreement.
Limited Liability Companies
A Limited Liability Company (“LLC”) is a hybrid business entity which contains elements of a partnership and a corporation. LLCs consist of members and managers. An LLC may provide tremendous benefits for its members, which include asset protection, intergenerational transfers, tax saving strategies, wealth preservation, and flexible management structures.
There are two types of structures in which LLCs operate. There are member-managed and manager-managed LLCs. In member-managed LLCs, the members of the company manage the company by voting in accordance with each member’s interest in the LLC. In manager-managed LLCs, members may appoint one or more managers to conduct the business activities that fall within the scope authorized by the company’s members.
An LLC can be taxed as a disregarded entity, partnership, cooperative, or corporation. By default, a multi-member LLC is taxed as a partnership. By default, a single-member LLC is taxed as a sole proprietorship (i.e., disregarded entity). Under such classification, the member is considered self-employed and is consequently responsible for self-employment taxes. If the LLC is not taxed as a C corporation, then it will be taxed as a pass-through entity. The earnings and expenses will pass through to the member’s personal tax returns. Under a pass-through scenario, the LLC itself will file Form 1065, but it will not pay the income taxes on the LLC’s profits.
There are generally two types of tax treatments available to corporations under the federal rules. By default, a corporation is taxed under Subchapter C of the Internal Revenue Code. However, a corporation may elect to be taxed under Subchapter S of the Internal Revenue Code.
In order to qualify as an S corporation, (1) the entity must be a domestic corporation, (2) it generally cannot have more than 100 shareholders, (3) it must have only one class of stock, (4) the business must satisfy the definition of a small business corporation under Section 1361 of the Internal Revenue Code, and (5) shareholders that are individuals must generally be U.S. citizens or residents (shareholders that are corporations or partnerships are generally excluded).
The shareholders of S corporations are required to pay estimated taxes if their own tax returns have exceeded or are expected to exceed $500 when the returns are filed. The shareholders are required to report all applicable categories of earnings and losses on Schedule K-1. The shareholders must pay taxes on their share of the corporate income regardless of whether distributions are made.
Trusts are created and operated under the laws of the state in which they are formed. A typical trust generally consists of a Trustor, Trustee and Beneficiary. The Trustor (a.k.a., Grantor, Settlor) is the original owner of the property. The Trustee is the fiduciary party that manages the trust assets. The Beneficiary is the designated party that is entitled to receive the trust income or assets.
A trust may be created during an individual’s life or after death under an individual’s will. A trust may also be a grantor trust or a non-grantor trust. If it is a grantor trust, then it is not recognized as a separate entity for federal income tax purposes. The most common types of grantor trusts are Revocable Living Trusts, which allow the Trustor (i.e., Grantor) to make changes or end the trust during his lifetime. Many people use Revocable Living Trusts as alternatives or supplemental to wills.
A non-grantor trust is any trust where the assets are not held by the grantor either directly or indirectly. A non-grantor trust is considered a separate legal entity. The most common of these trusts are irrevocable trusts, where the trust cannot be revoked once it is created. The transfer of the asset is deemed a complete gift with gift tax implications. The income and deductions of non-grantor trusts are reported on Form 1041 (Income Tax Return for Estates and Trusts).
An estate is created when a person dies. Upon the distribution of all assets and satisfaction of all liabilities, both estates and trusts generally cease to exist. The assets of the estate must generally be treated on the beneficiary’s return in the same manner as they are treated on the estate’s return. In addition, the estate’s gross income, deductions and credits are calculated in the same manner as that of an individual. However, they are reported on Form 1041 only if the estate’s annual gross income exceeds $600.
The beneficiary who inherits the property is generally not taxed on the transfer. However, until the distribution is made, the beneficiary may be subject to income tax if she is receiving distributions before the final distribution of the estate (e.g., during the course of a litigation dispute). Any distributions made to a beneficiary are reported on Schedule K-1.
NEW DEDUCTION UNDER TCJA
The Section 199A deduction is only available to owners of pass-through entities. It will take effect from the 2018 tax year and it is set to expire after December 31, 2025 unless otherwise extended by Congress. The maximum potential amount of the deduction is 20% of the Qualified Business Income (“QBI”) from each business the taxpayer owns. For active business owners, the portion of the business income is generally the remaining portion after a business owner receives reasonable compensation (e.g., W-2s).
The eligibility for the QBI deduction is first determined by the taxpayer’s total taxable income (e.g., business and investment income) minus adjustments (e.g., deductions). The second inquiry is how much the taxpayer is entitled to deduct. There is generally an “overall limitation” which is determined by the lesser of the combined net business income or 20% of the total taxable income (in excess of any net capital gain). For taxpayers who only receive business income from passive avenues (e.g., rental real estate), the overall limitation is generally sufficient to determine the QBI deduction. It gets more complicated for taxpayers who operate active businesses.
The analysis below focuses on owners of active businesses, such as professionals or entrepreneurs who own and also operate their businesses. Besides the overall limitation test, there are primarily two overarching tests that are used to determine the amount the taxpayer may deduct: the type of business the taxpayer operates and the taxpayer’s total taxable income.
Type of Business Test
Whether the taxpayer provides services in a Specified Service Trade or Business (“SSTB”) within the meaning Section 199A is a significant factor in determining how much the taxpayer is entitled to deduct. If the taxpayer falls in any of the enumerated classifications as outlined in Section 199A, her deduction may either be reduced or she may not be entitled to any deduction. If the taxpayer provides services in a SSTB, she may not be entitled to any deduction beyond a certain threshold, even though a similarly situated taxpayer may otherwise be entitled to receive a deduction.
There are two classifications of SSTBs within the meaning of Section 199A. The first classification defines SSTB as “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services” (architects and engineers are expressly excluded under 199A). The second classification involves the performance of services in the areas of investing and investment management, trading or dealing in securities, partnership interests, and commodities.
The first classification also includes a catch-all category of “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” Even though the term “trade or business” is not defined by statute, the factors that may be considered include the profit motive of the business owner and the continuous and regular activity of the business. The proposed regulations limit the definition of “reputation or skill” to (1) income from endorsing products or services, (2) licensing or receiving income for the use of an individual’s likeness, or (3) receiving appearance fees from various media platforms such as television.
Total Taxable Income Test
The key factor for determining the QBI deduction is the taxpayer’s total taxable income. If the total taxable income falls in Tier 1, regardless of whether the taxpayer’s business meets the SSTB test, the taxpayer may be entitled to the maximum deduction. If the taxable income falls in Tier 2, the amount of the QBI deduction is generally reduced. If Tier 3, depending on whether it is SSTB, the QBI deduction is either limited or the taxpayer is not entitled to any deduction.
The threshold of the total taxable income for Tier 1 is $157,500 ($315,000 if filing a joint return), Tier 2 is $207,500 ($415,000 if filing a joint return), Tier 3 is any amount that is in excess of $207,500 ($415,000 if filing a joint return).
Assuming the taxpayer falls in Tier 1, the maximum the taxpayer may deduct is 20% of his combined net business income. This means that the taxpayer who earns $100,000 on his QBI may pay tax only on $80,000. If we assume that the taxpayer falls in the 24% tax bracket, the taxpayer would pay 24% tax on the $80,000 portion (as opposed to the full $100,000). Therefore, the taxpayer would pay only $19,200 on the QBI portion (instead of $24,000).
If the taxpayer falls in Tier 2 or Tier 3, there is a wage and capital (i.e., Qualified Property) limitation. Qualified property is any tangible property that is subject to depreciation and is available for use during the tax year. The depreciation period is determined by the later of the regular depreciation period that would apply to the particular property or 10 years. The 2.5% calculation in the formula is determined by the unadjusted basis of the property, meaning, the basis of the property immediately after its acquisition.
Taxpayers who fall in Tier 2 are subject to a phase-in of the W-2 and Qualified Property limitation. This is true regardless of whether the taxpayer operates an SSTB. However, there are differences between owners of SSTBs versus owners of non-SSTBs when calculating the QBI deduction for Tier 2.
Generally, the formula used to calculate the QBI deduction for taxpayers who fall in Tier 2 is determined by the portion of the taxpayer’s total taxable income that is in excess of the Tier 1 threshold yet below the Tier 3 threshold. The difference is then divided by $50,000 ($100,000 for joint filers). For MFJ taxpayers who operate SSTBs, the formula for the QBI deduction is [1 – (taxable income – $315,000) / $100,000)] x (QBI x 20%).
To illustrate the application of the SSTB formula for Tier 2, let’s assume that Larry and his wife operate a law firm (SSTB), which is taxed as an S corporation. In 2018, the couple’s taxable income is $345,000 and QBI is $95,000. If we apply the formula above, their QBI deduction for 2018 is $13,300 based on [1 – ($345,000 – $315,000) / $100,000)] x ($95,000 x 20%).
If the taxpayer’s taxable income falls in Tier 3, the next inquiry is whether the taxpayer’s business falls within the realm of SSTB. If it is SSTB, the inquiry ends here and the taxpayer is not entitled to any QBI deduction. If it is not SSTB, then the deduction is equal to the lesser of: (a) 20% of net business income or (b) greater of (i) W-2 x 50% or (ii) W-2 x 25% + 2.5% of Qualified Property.
In order to understand the application of the formula for Tier 3, assume that Ronald owns and operates a golf course (not SSTB). In 2018, Ronald’s total taxable income is $400,000. His entire income is from the operation of the golf course. Ronald also purchased $1,000,000 worth of golf clubs and other Qualified Property that have not fully depreciated. Since Ronald operates as a sole proprietor, he cannot receive W-2s. Thus, his QBI deduction is $25,000 because $25,000 is the lesser of: (a) $80,000 (20% x $400,000) or (b) greater of (i) 0 (zero W-2 x 50%) or (ii) $25,000 [0 (zero W-2 x 25%)] + [$25,000 ($1,000,0000 x 2.5%)].
Assume the same facts as in the example above, except that Ronald is a shareholder-employee of an S corporation and received $100,000 in W-2s. He does not have any Qualified Property (e.g., golf clubs). His QBI deduction is $50,000 because $50,000 is the lesser of: (a) $80,000 (20% x $400,000) or (b) greater of (i) 50,000 ($100,000 W-2 x 50%) or (ii) $25,000 [$25,000 ($100,000 W-2 x 25%) + 0 (zero x 25%)].
Since the taxpayer’s total taxable income is arguably the biggest factor in determining eligibility for the QBI deduction, one technique is to reduce the taxable income to the extent possible. There are various ways to achieve that end. One way is to implement defined benefit or defined contribution plans. If done correctly, these plans may reduce the taxable income, provide asset protection, and secure a peace of mind for the latter years of a person’s life.
Another technique is to restructure the business entity. For shareholder-employees of C corporations, it may be better to restructure as a S corporation since 199A is available only to pass-through entities. For sole proprietors and partners of partnerships who fall in Tier 2 or Tier 3, they are generally not entitled to the deduction because they cannot receive W-2s. However, if there is Qualified Property, they may be entitled to the deduction. In any event, converting to a S corporation is not only beneficial for asset protection purposes and reducing the AGI, but it may now also be beneficial for the QBI deduction.
To illustrate the significance of the impact of entity structures, let’s assume that Tommy and Dolly (a married couple) operate an online shopping business. The business has no Qualified Property, but in 2018, it generated $500,000 of QBI and $550,000 of taxable income. If the business is treated as a sole proprietorship or partnership, the couple will not be entitled to any QBI deduction. If it is treated as an S corporation, they may be entitled to a deduction in the amount of $50,000 assuming that they pay themselves $100,000 in W-2s.
Important Note: Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance on its use. Additionally, certain changes in law may affect the legality of the information provided above and certain circumstances of the reader may vary the applicability of the above content to his or her situation.Read More
A Limited Liability Company (“LLC”) is a hybrid business entity which contains elements of a partnership and a corporation. LLCs consist of members and managers. An LLC may provide tremendous benefits for its members, which include asset protection, intergenerational transfers, tax saving strategies, wealth preservation, flexible management structures, and clarity on the roles of all essential parties involved in the company as set out in the Operating Agreement.
The following five concepts are fundamental for establishing an LLC: Asset Protection, Intergenerational Transfers, Tax Saving Strategies, Management, and Funding.
Generally, the more assets a person owns in one’s name, the more likely it is that he or she will be a target mark for creditors. This is why it’s good practice to own as little as possible in your own name. In order to accomplish this goal, it’s important to evaluate the types of asset protections tools that are available to you. An LLC is one such tool that is effective for asset protection purposes.
For creditors of the LLC itself, a member’s personal liability will generally be limited to the amount of the member’s investment in the LLC unless the member personally guarantees the transaction in question.
For creditors of the member of the LLC, a creditor is generally precluded from acquiring an interest in the debtor-member’s interest in the LLC if the judgment was entered after the LLC was formed. However, most states allow for a judgment creditor to levy on assets after distributions have been made to the debtor-member by the LLC.
As a general rule, a creditor has no right to become a member, compel a distribution, or demand company assets. If such rights were given to a creditor, then the other members of the company would suffer from an action or inaction of a particular member. This would inevitably lead to an unjust result for the remainder of the group. Therefore, the creditor must wait until distributions are made to the member before any potential recovery can be pursued.
Another limitation on a creditor’s pursuit on a claim against the debtor-member is that an Operating Agreement has the power to prevent non-members from acquiring an interest in the company. This is especially important in the case of failed marriages and judgment creditors because courts may at times issue overreaching rulings in order to accomplish an equitable outcome in the event of divorces or other circumstances. An LLC can also provide the means for family members or ex-family members who are in dispute to not be compelled to communicate at the time their interest is being transferred from their donors to them.
There is another layer of asset protection that deals particularly with the recipients of the LLC interest. It’s standard practice for owner-members to make gifts to their heirs throughout their lives. Several problems are immediately surfaced when gifts of substantial value such as property or a significant amount of cash are transferred to their heirs. Without a proper plan in place, the recipients are likely to subject these assets to waste or relinquish them to creditors or former spouses. However, the transfer of an interest in the LLC can protect these assets from loss or waste by the recipient-members.
Keep in mind that the asset protection planning must be done well in advance of any anticipation to a claim. That’s because fraudulent transfers are broadly construed. Intent is generally presumed if a transfer is found to have been made before or after the claim arose with the intent to defraud, hinder, or delay a known creditor. If the transfer is deemed fraudulent by the court, the court may set aside the transfer, which may also lead to criminal consequences.
An LLC is the preferred homeplace for many types of properties, including real estate. Real estate held for the purpose of investment is a ubiquitous phenomenon. Yet in practice, it is widespread to see title to its ownership being held in an individual’s name. In fact, if an investor owns multiple income-producing properties, it’s recommended (subject to some exceptions) to form and operate a separate LLC for each piece of property. In the case of a primary residence, transferring title to a living trust is the preferred method primarily due to tax advantages and the homestead exemption.
One of the reasons for forming a separate LLC for an income-producing real estate is that an injury on its premises can be costly even if the insurance policy satisfies a portion of the claim. Thus, if an entity only owns one piece of real estate, the claims will only be limited to that piece of property. If, however, the entity owns other assets, all such assets are at the risk of being exposed to the creditor.
Let’s also not forget one crucial point in the context of asset protection. By merely establishing an LLC, it will not be enough to be sheltered from personal liability. Formalities must be followed to embolden the shield of limited liability (just like for corporations or other types of entities that are subject to limited liability). If formalities are not adequately followed or there is a personal guarantee against the particular risk in question, the member’s personal assets will likely be exposed to the creditor.
It’s also equally important to make sure that the business is never conducted in the individual member’s capacity, but only in business capacity. For example, as “Manager” or “Member.” In the context of distributions, the accounting must continuously be updated as the distributions are being made to the members. The lack of formalities will give more weight to the argument that the LLC had no business purpose and should be disregarded as a separate legal entity.
Despite all the asset protection tools, a creditor has a few recourses (some of which go beyond the scope of this article). The one recourse that is generally available to a creditor is commonly referred to as a “charging order.” A charging order permits a creditor to seize only those assets that have been actually distributed, but not the assets that the debtor-member may potentially be entitled to receive under his or her ownership interest in the LLC.
Charging orders are better known as “phantom income” for a reason. The IRS requires for the members of the LLC to pay income tax even if they do not receive any distributions. In the case of charging orders, the creditor would be required to pay income tax on the debtor-member’s interest in the LLC even if the creditor does not receive any actual distributions. This is perhaps the most deterring factor on a creditor’s pursuit in recovering from an LLC because a creditor generally ends up in a worse position than before his pursuit of the charging order. Additionally, a creditor’s tax bracket may also increase as a result of the charging order.
An LLC can be structured in such a way to protect the assets of a family for generations. These are otherwise known as Family Limited Liability Companies (“FLLC”). Even though such entities are structured and operated just like typical LLCs, most, if not all of the assets, are owned by the family in FLLCs.
In general, LLCs have some of the same benefits as living trusts when it comes to intergenerational transfers. An LLC can provide for a smoother transfer of wealth upon the death of an owner by avoiding probate. It can further prevent assets from going through probate in the event of a member’s disability and even in guardianship or conservatorship proceedings.
Another similarity with a living trust is that the nature and character of the underlying assets of the company are private. In other words, details as to what assets the LLC owns will generally be outside the scope of the public domain. As opposed to probate, where the circumstances surrounding the transfers of the decedent’s assets are a matter of public record, transfers of LLC assets are generally accomplished under private circumstances.
The effective planning techniques involve not only how the assets will be transferred when the owner of those assets dies, but to also employ techniques that will allow the transfer of assets during the donor’s life. In the context of FLLCs, there is a planning method available through gifting which allows for senior family members to periodically gift a portion of their assets to their younger family members.
There are some assets, however, that by their nature make it difficult to gift in fractions. Transferring portions of real estate, farm, or other assets are difficult to calculate especially when their value can fluctuate on a daily basis. There are some factors that may make the particular asset periodically more or less valuable: external market conditions and the overall condition of the asset. However, the gifting of an interest in an LLC avoids the trouble of transferring a fraction of a particular asset.
Regardless of the type of asset being transferred, there are incentives in place for transferring wealth during a donor’s life. These incentives can range from reducing the donor’s taxable estate to providing for the living expenses of the donor’s children. As such, the implementation of an annual gifting method may play a significant role in the periodic transfer of wealth from the older family members to the younger ones.
In 2018, the annual exclusion amount is $15,000 for individual taxpayers. Under the taxation rule of gift-splitting, a married couple can transfer $30,000 to any individual without being required to pay a Gift Tax or having to file a Gift Tax Return. To illustrate the significance of annual gifting, suppose that a married couple has four children. The couple can potentially remove $120,000 per annum from their estate without the Gift Tax consequences.
An LLC can also provide an excellent tool for gifting an interest during the donor’s life without commingling the gifted portion of the assets with the recipient’s other assets that have been accumulated during his or her marriage. After the membership interest is directly transferred to the recipient or in a separate property trust that has been specifically established for the recipient, the “paper trail” can show that a particular asset (whether in the form of cash or other property interest) is in fact the separate property of the recipient-member.
In the context of LLC ownership transfers, it is the member’s interest – not the actual asset – being transferred. Thus, the interest is adjusted in value due to lack of marketability. That’s because the assets that are subject to the LLC generally have limitations. Such limitations may include the right of first refusal, the inability to demand a distribution, order a dissolution, or participate in the management of the LLC.
The fundamental reason for the lack of marketability is that the membership interest is not a liquid asset and generally cannot be freely assigned. In other words, if the buyer cannot indeed purchase the piece of a parcel, but instead he or she can only purchase a potential ownership interest in the parcel (e.g., by owning X% in the LLC) with some of the previously mentioned limitations, the value of the membership interest will be discounted in accordance with the limitations.
The discounting aspect for lack of marketability is especially useful in the context of gifting. For instance, if a member’s interest is discounted by 1/3 due to lack of marketability, a gift of $10,000 in the form of an LLC interest is equivalent to a gift of $15,000 in the underlying assets of the LLC ($15,000 x 2/3 =$10,000).
Upon the death of the owner-member, value adjustments may also apply to the remaining portion of the deceased member’s interest in the LLC based on lack of marketability. A general formula for calculating the taxable value of the estate of the deceased-member’s interest is the following:
% of ownership x FMV (1 – discount) = Estate Tax Value
Tax Saving Strategies
An LLC can be taxed as a disregarded entity, partnership, cooperative, or corporation. By default, a multi-member LLC is taxed as a partnership. By default, a single-member LLC is taxed as a sole proprietorship. Under such a classification, the member is considered self-employed and is consequently responsible for self-employment taxes (Social Security and Medicare).
For income tax purposes, sole proprietorships, partnerships, and S-corporations are classified as pass-through entities. This means that the income and expense will pass through to the owner’s personal tax returns. Under a pass-through scenario, the LLC itself will file a Form 1065 tax return, but it will not pay the income taxes on the LLC’s profits.
One strategy for lowering a member’s taxable income is to not have them actively participate in the management of the LLC. Members who do not participate in the management of the company will generally be exempt from paying the self-employment tax. Therefore, their overall income tax may be reduced since they will not pay the self-employment tax on the LLC portion of their income.
Another way to reduce the overall income taxes during the members’ life is by spreading them among members who happen to fall in lower tax brackets than the owners. This is especially useful in the context of FLLCs since younger family members may not necessarily earn as high of an income as their elder counterparts.
Another benefit of an LLC is that a transfer of an asset by an individual to the LLC is normally not a taxable event unless otherwise excepted. Similarly, transfers upon the dissolution of the LLC are also not taxable since they are deemed a return of capital. Of course, gain may be recognized if the asset is sold by the individual after the asset has been transferred from the LLC.
The general tax consequence on transfers (to and from) an LLC is especially significant when considering that virtually any transfer from one entity to another can either be accomplished by sale or gift. If it’s a sale, then the transferor must generally pay capital gain taxes if the asset has appreciated in value since its purchase. If it’s a gift, there may be gift tax consequences. In this case, we have the owner being a separate entity, transferring to the LLC (also a separate entity). Nonetheless, these transfers generally do not qualify as taxable events for IRS purposes.
In the context of FLLCs, calculating the basis of assets or membership interests can be problematic, especially if such assets are sold generations after their purchase. This will inevitably affect the basis adjustments of those assets. The basis of an asset is what the original owner paid for its purchase. Several factors may affect the adjustment of the basis by either increasing the original basis (e.g., capital improvements) or by decreasing the original basis (e.g., depreciation deductions).
The similar concepts on basis adjustments apply to a member’s interest in the LLC because these interests also have their own basis. If there are many assets with different basis inside the LLC, it can become a logistical nightmare for accountants and administrators to calculate each member’s separate basis in the LLC. Thus, mixing different assets in the same LLC can be problematic especially in the context of multi-generational entities (e.g., FLLCs). Instead of being limited to one LLC, it is recommended to consider additional or subordinate LLCs especially for preventing such problems down the road.
The last point with regard to tax consequences of LLCs pertains to state law. When forming an LLC, it’s essential to consider all of the laws that the state provides on the formation and governance of LLCs. Some states have favorable laws with regard to LLCs versus other business types of entities; other states tend to be less favorable.
Management of an LLC
LLCs consist of members and managers. If we can make an analogy with corporations, members would be equivalent to the shareholders of a corporation; whereas managers can be a hybrid between Board of Directors and senior officers of a corporation (depending on the scope of authority provided by the members and the Operating Agreement).
There are two types of structures in which LLCs operate. There are member-managed and manager-managed LLCs. In member-managed LLCs, the members of the company manage the company by voting in accordance with each member’s interest. In manager-managed LLCs, members appoint one or more managers to conduct business activities that fall within the scope authorized by the company’s members.
There is no requirement for a manager to be a member of the LLC. Even in a member-managed LLC, the members may appoint a manager to be responsible for the daily business operations, but nevertheless be prevented from exercising any decision-making management authority.
A managing entity is recommended for a variety of reasons. First, as opposed to an individual, a managing entity does not have the same limitations as a human being might have, including disability and death. Since managers generally answer to members, the level of control over investment decisions can be set by the members in accordance with the manager’s fiduciary duty to the LLC. The level of control may vary from how much income to distribute or reinvest to being limited to only managing simple day-to-day operations.
An LLC formed in California must have an Operating Agreement. The Operating Agreement sets forth the scope of authority of members and managers. It can also provide restrictions on the transferability of membership interests and determine the form of compensation of its managers. A membership interest can be in the form of percentage or membership units. Membership units are analogous to owning shares in a corporation.
There are generally four ways members can receive compensation from the LLC. First, the General Members can receive management fees for managing the company. Such compensation can even be in the form of “preferred equity interest,” whereby a certain percentage of income is paid to the individual or entity holding that interest.
The second way is for the LLC to make distributions to the members. In such a scenario, the limited members will generally be entitled to a pro rata share from the distributions. The third way is for the LLC to make loans to the members. This strategy should be implemented with extreme caution. The fourth way provides an option to the limited members to potentially purchase a more significant share in the LLC from the owners, thereby resulting in more direct income for the owners.
Funding the LLC
Funding is the process of transferring assets to the LLC. Funding is an essential step in order for the LLC to be legally enforceable. An LLC must have a business purpose. If the LLC does not have any assets or is not otherwise funded, it follows that it does not have a business purpose.
The similar concept of funding applies to revocable living trusts. If a revocable living trust does not have any assets, it can be the most potent trust instrument ever written, but it will generally have no legal effect. Therefore, an LLC must also be properly funded, for among other things, to potentially grant limited liability to its members.
The means for funding the LLC may vary from asset to asset. For example, different standards apply when real estate is transferred onto the LLC as opposed to a publicly traded security company. As a baseline rule, the transfer of an asset to the LLC must happen in the same manner in which title to the particular type of property is held. In case of real estate, such transfers may only be effectuated by deeds, regardless of whether the transfer is from person to person, or from (or to) an LLC.
Notwithstanding the type of asset being transferred, the value of the asset must be determined at the time of transfer. Determining the valuation of real estate and business interests in firmly held companies or LLCs is not an exact science. Consequently, such assets may be required to be appraised by a qualified appraiser (someone with an excellent reputation in the field of appraisals and a successful track record for audits). To justify any valuation discounts in the event of litigation or potential challenges by taxing authorities, qualified appraisals should also value the interest in the LLC at the time the member’s interest is either sold or gifted or when one of the members dies.
The transfer of stocks, bonds, and other securities to an LLC is accomplished by a stockbroker, the issuing company, or a third party agent. If a stockbroker is used to facilitate the transfer, it’s recommended for the stocks to be held in a “nominee securities” account. In other words, the brokerage account will be in the name of the LLC, however, the actual stocks will be held in the brokerage company’s name.
One final point concerning funding to keep in mind when it comes to stocks and investment assets are the “anti-diversification rules.” Generally, the transfer of an asset to the LLC is not a taxable event unless the transfer triggers an immediate tax consequence within the meaning of diversification of securities.
Several standards are used to determine issues related to diversification. First, “The 80% Rule” states that if 80% or more of the assets of the LLC are marketable securities, the LLC can be classified as an “investment company.” As a result, the anti-diversification rules may apply and tax may be due on the transfer. Therefore, if 20% or more of the assets are made up of real estate, the anti-diversification rules will not be triggered and no tax would be due on the transfer provided that real estate assets remain at 20% or more in the LLC after the transfer.
Second, “The Non-Identical Assets Rule” applies in a scenario where one person contributes one type of stock and another person contributes another type of stock, the anti-diversification rule may be triggered. However, if the same two people were to contribute two of the same stock or if one person contributes all of the assets (even if they are not identical), the anti-diversification rules will generally not be triggered.
Third, “The 25% Test and 50% Test” states that no diversification can occur when the transferor transfers a diversified portfolio of securities to the LLC which contains no more than 25% of the value of all securities from one issuer and no more than 50% of the value of all securities from five or fewer issuers. In this instance, the portfolio itself is considered diversified since it does not contain any one issuer which represents more than 25% of the value of the total securities nor five or fewer issuers which represent more than 50% of the securities in the same portfolio. Similar to mutual funds, diversification rules generally do not apply to a portfolio that is being contributed to the LLC that is already diversified.
The crux of the matter regarding the anti-diversification rules is that if an LLC owns securities and the LLC itself is in fact performing the functions of an investment company within the context of securities, then any asset being transferred (including cash) to the LLC may be subject to tax. The application of these rules can be pernicious and planning around them must be done with extreme caution to minimize the likelihood of a tax being due on a transfer.
The rigorous legal standards surrounding LLCs increase the likelihood for the LLC to lose its asset protection status against creditors or to be successfully challenged by taxing authorities. The LLC provides tremendous benefits to its members: asset protection, intergenerational transfers, tax saving strategies, flexible management structures, and wealth preservation. In order to enjoy all the benefits that an LLC has to offer, it’s important to be in constant contact with qualified advisors, including attorneys, CPAs, tax specialists, and financial advisors to make sure that all applicable legal matters are properly addressed in advance.
Remember that an LLC is a business, it must have a business purpose, and it must be operated as a business. Problems are bound to occur when the owners of LLCs deviate from these standards and become overconfident in the notion that their LLC is an enforceable legal entity that is unequivocally protected against creditors and taxing authorities by virtue of its existence.
Important Note: Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance on its use. Additionally, certain changes in law may affect on the legality of the information provided above and certain circumstances of the reader may vary the applicability of the above content to his or her situation.Read More