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Saving the Family Farm with Estate Planning and Business Entities Robert A. Tufts, Ph. Saving the Family Farm with Estate Planning and Business Entities Robert A. Tufts, Ph. D. , J. D. LLM (tax) School of Forestry and Wildlife Sciences Auburn University [email protected] edu (334) 844 -1011 2

Landowner Concerns Landowners need and want opportunities to generate income from their property while Landowner Concerns Landowners need and want opportunities to generate income from their property while protecting it for future generations l Two barriers they encounter to meeting their objectives are: l • Estate taxes and • Fragmentation of ownership when passed to the next generation • If a father owned a 500 -acre working farm and gave it equally to his five sons and those five sons gave equally to their five sons, in two generations the 500 -acre farm would be reduced to 25 20 -acre parcels 3

Estate Taxes l American Taxpayer Relief Act of 2012 • Reunified gift and estate Estate Taxes l American Taxpayer Relief Act of 2012 • Reunified gift and estate taxes • $5, 000 applicable exclusion amount made permanent and adjusted for inflation • 40% maximum tax rate • Portability made permanent l A recent Congressional Research Service Report states that less than 0. 2% of decedent’s estates will be affected by transfer taxes • Transfer taxes include gift, estate and generationskipping transfer taxes 4

Historical Applicable Exclusion Amounts Year AEA ($) Tax Rate (%) 2001 675, 000 55 Historical Applicable Exclusion Amounts Year AEA ($) Tax Rate (%) 2001 675, 000 55 (5 surcharge) 2002 -3 1, 000 50; 49 2004 -5 1, 500, 000 48; 47 2006 -8 2, 000 46; 45 2009 3, 500, 000 45 2010 no tax or 5, 000 0 or 35 4

Applicable Exclusion Amounts Year AEA ($) Tax Rate (%) 2011 5, 000 35 2012 Applicable Exclusion Amounts Year AEA ($) Tax Rate (%) 2011 5, 000 35 2012 5, 120, 000 35 2013 5, 250, 000 40 5

Portability l Portability is the opportunity for the surviving spouse to use a deceased Portability l Portability is the opportunity for the surviving spouse to use a deceased spouse’s unused applicable exclusion amount (Deceased Spousal Unused Exclusion) • For 2013 each spouse has an applicable exclusion amount of $5, 250, 000; so, a couple could transfer $10, 500, 000 to the next generation without taxes • Eliminates the need for the credit shelter trust and dividing asset in estate planning 7

Estate Tax Planning Estate tax planning is essentially a gifting program where assets are Estate Tax Planning Estate tax planning is essentially a gifting program where assets are transferred to the younger generation for no or reduced taxes l Benefit of lifetime transfers l • Removes income and appreciation • Effective gift tax rate is lower (rate is the same but the base is different) • Gifts are tax exclusive • Estates are tax inclusive 8

Example of Gift versus Estate Suppose a 55 -year old parent wants to transfer Example of Gift versus Estate Suppose a 55 -year old parent wants to transfer a property with a value of $1 million to a child l If the transfer was taxable l • Parent would need $400, 000 (40% of $1, 000) to pay the gift tax • Parent’s estate would need $666, 667 in addition to the property for the child to receive the property ($1, 666, 667 estate time 40% tax = $666, 667 tax) • suppose parent lived 10 more years and the property appreciated 4% per year then the property value would be $1, 480, 244 and the estate would need $986, 830 to pay the tax 9

Example of Gift versus Estate l Adding basis to the example • The donee Example of Gift versus Estate l Adding basis to the example • The donee takes the donor’s basis plus tax paid on the appreciation § 1015 • A devisee (estate) gets a step-up (or down) to FMV date of death § 1014 l If the basis in the $1 million property were $600, 000 • The donee’s basis would be $760, 000 ($600, 000 plus tax paid on the appreciation ($400, 000 * 40% = $160, 000) • There is a built-in LTCG tax of $36, 000 ($240, 000 * 15%) • The devisee would get the FMV date of death or $1 million 10

Estate Planning Estate tax planning is essentially a gifting program to reduce the size Estate Planning Estate tax planning is essentially a gifting program to reduce the size of the estate l First, use tax-free gifts to the extent possible l Second, use annual exclusion gifts § 2503(b) l Third, make gifts up to the available applicable exclusion amount (since gifting removes income and l appreciation) • Use split-interest gifts (QPRT’s, GRAT’s etc. ) or gifts that qualify for a discount (minority interests in a business entity) 11

Discounted Gifts Business entities are also used for succession planning l Gifting a minority Discounted Gifts Business entities are also used for succession planning l Gifting a minority or non-management interest in a business entity qualifies for a discount l The discount depends on the type of asset the business owns and the value needs to be determined by a qualified appraiser; however, discounts of 35% are not uncommon l 12

Discounted Gifts l The value of the interest is the price at which the Discounted Gifts l The value of the interest is the price at which the interest would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts 1 13

Discounts l Lack of control l Lack of marketability • Little voice in partnership Discounts l Lack of control l Lack of marketability • Little voice in partnership operations • Cannot obtain pro rata share by compelling liquidation • Cannot obtain the value of his interest by redeeming it • Cannot transfer his management rights • Cannot compel distributions • Must pay taxes on his allocable share • Few unrelated parties would be interested in a minority interest in a family partnership without a substantial discount 14

Preventing Fragmentation with a Business Entity or Trust Management of the family farm is Preventing Fragmentation with a Business Entity or Trust Management of the family farm is a typical problem for second- and third-generation owners l Parents typically leave undivided interests rather than having property surveyed and divided l As the number of owners increases it becomes difficult to agree on management objectives l Partition is the only remedy when joint owners cannot agree l A trust or business entity can be used to benefit children equally while vesting the management in one or two individuals l 15

Business Entities in Alabama • Single Owner • Sole proprietorship • Limited liability company Business Entities in Alabama • Single Owner • Sole proprietorship • Limited liability company • Corporation, S or C • Business trusts l Multiple Owner • General partnership • Registered limited liability partnership • Limited liability limited partnership • Limited liability company • Corporation • Business Trust • Cooperative • Real estate investment trust

Liability of Owners GP/RLLP LP LLC Corp. All partners are liable jointly and severally Liability of Owners GP/RLLP LP LLC Corp. All partners are liable jointly and severally for all obligations of the partnership General partners are jointly and severally liable for the debts of the LP Limited partners are not personally liable Members are not liable for obligations of the LLC for acts or omissions of any other member A shareholder is not personally liable for the acts or debts of the corporation (except amount contributed) A partner in an RLLP is not personally liable The GP’s in an LLLP are not personally liable A member may become liable “Piercing the because of his own corporate veil” conduct.

Participation in Management GP/RLLP LP LLC Corp. Partners have a statutory right to participate Participation in Management GP/RLLP LP LLC Corp. Partners have a statutory right to participate in management – majority rules on ordinary decisions General partners participate in management but Limited partners are prohibited from participating in management – majority rules on ordinary decisions Members or managers may participate in management as provided in the articles of organization Shareholders participate in management by electing directors to determine policy and appoint officers

Transferability of Interest GP/RLLP LP LLC A partner’s or member’s interest is transferable, but Transferability of Interest GP/RLLP LP LLC A partner’s or member’s interest is transferable, but the assignee only gets the income interest. Unless provided otherwise the assignee only becomes a partner/member with the unanimous consent of the other partners/ members. The partnership/operating agreement can limit a partner/member’s right to withdraw or assign his interest. Corp. Shares are freely transferable, subject to restrictions in the organizational documents

Allocation of Profits and Losses GP/RLLP LLC Per capita (regardless of contribution), unless modified Allocation of Profits and Losses GP/RLLP LLC Per capita (regardless of contribution), unless modified by the partnership agreement. In general, may be allocated in any manner the partners agree so long as the allocation is in accordance with the partners’ interests or otherwise has substantial economic effect. LP Corp. Pro rata to contributions (unless modified by the partnership agreement) Profits – pro rata to number of shares, (plus salary) C-corp. – only profits are passed to s/h S-corp. – profits and losses are allocated to s/h

Creditor Rights GP/RLLP LP A creditor can get a charging order. A creditor may Creditor Rights GP/RLLP LP A creditor can get a charging order. A creditor may get a judicial winding up LLC Corp. C-corp. : creditor can seize stock S-corp. : creditor can seize stock

Classification for Tax Purposes GP/RLLP LP LLC Corp. Generally taxed as a partnership which Classification for Tax Purposes GP/RLLP LP LLC Corp. Generally taxed as a partnership which means “flow A C-corp. is subject to through” taxation (entity files an information return, but the double taxation owners pay the tax on their individual returns. ) An S-corp. is taxed Income is from self-employment so FICA rate = 15. 3%, similar to a except for limited partners or members who are not partnership managers and S-corp. shareholders (not salary) Entity can elect to be taxed as a corporation.

Business Entities l For estate planning • limited liability companies (LLC’s) or • limited Business Entities l For estate planning • limited liability companies (LLC’s) or • limited partnerships (typically called family limited partnerships (FLP’s) and now • limited liability limited partnerships are the preferred entities 23

Desirable Characteristics of the LLC, FLP and LLLP l Maintain control while giving interests Desirable Characteristics of the LLC, FLP and LLLP l Maintain control while giving interests to family members (unity of management) • Avoids veto power of small owners Owners can transfer income interest but not management rights l Prevent interests in family property from passing to outsiders as a result of death, divorce or other disposition l Limited liability l Creditor/asset protection l 24

Desirable Characteristics of the LLC, FLP and LLLP Limited withdrawal rights l Discounted values Desirable Characteristics of the LLC, FLP and LLLP Limited withdrawal rights l Discounted values for entity interests l No taxation at the entity level l Facilitating gifts l Perpetual life l Avoids the difficulties with fractional interests l Avoids ancillary probate l Can be used to reduce estate taxes l Provides a succession plan l 25

Disadvantage of the LLC, FLP or LLLP When the parents can no longer manage Disadvantage of the LLC, FLP or LLLP When the parents can no longer manage the business (age, infirmity or death) the younger generation will assume control l Once the next generation controls the business they can dissolve it (requires a super majority) l 26

Trust l An agreement between a grantor and trustee that sets management and distribution Trust l An agreement between a grantor and trustee that sets management and distribution criteria • Grantor funds the trust • Trustee has legal title to the assets Assets are held for beneficiaries who have equitable title but not legal title or management rights l Trusts can be l • Revocable or • Irrevocable 27

Trust l Trustee can be a “corporate” trustee (bank trust department) or any competent Trust l Trustee can be a “corporate” trustee (bank trust department) or any competent individual, such as an attorney, accountant or even beneficiaries • Successor trustees are identified to continue management of the assets after the grantor’s death • Successor trustees have to abide by the distribution criteria of the trust, e. g. if the trust does not allow the sale of the family forest, then it cannot be sold by the successor trustees or the beneficiaries 28

Trust l The life of the trust is governed by the state’s rule against Trust l The life of the trust is governed by the state’s rule against perpetuities • Traditional rule was that an interest must vest within a life in being plus 21 years • In Alabama, a trust that holds real property can last for 360 years • Several states have abolished the rule against perpetuities; so, a trust in those state could have perpetual life 29

Trust The trust would have many of the advantages of a business entity, such Trust The trust would have many of the advantages of a business entity, such as limited liability, creditor protection, succession plan, etc. l Once the grantor loses competence, the trust becomes irrevocable meaning that there is no flexibility to change the distribution plan l 30

Revocable Trust Instead of a Will Trusts provide greater control over distributions, e. g. Revocable Trust Instead of a Will Trusts provide greater control over distributions, e. g. conditions and length of time l Privacy concerns – wills are public documents trusts are not l Avoid the expense and trouble of court-supervised proceedings l Property management in case of incapacity l

Revocable Trust Instead of a Will Protects residual beneficiaries l Creditors l Spousal election Revocable Trust Instead of a Will Protects residual beneficiaries l Creditors l Spousal election l Only disposes of assets in the trust l Statute of limitations is longer – 2 years v. 6 months l

Purpose of Estate Planning l Distribute your estate l Minimize/eliminate transfer taxes • Who Purpose of Estate Planning l Distribute your estate l Minimize/eliminate transfer taxes • Who • When

No Will Who takes care of your minor children l Problems for subsequent generations No Will Who takes care of your minor children l Problems for subsequent generations l • Who owns your property • Administrative headache • Additional expenses • Bond • Inventory

Basic Documents in an Estate Plan Advance directive for health care l Power of Basic Documents in an Estate Plan Advance directive for health care l Power of attorney l Distribution plan l • Will • Trust

Basic Documents in an Estate Plan l Advance Directive for Health Care (Living Will Basic Documents in an Estate Plan l Advance Directive for Health Care (Living Will and Health Care Proxy) • Directions if you are terminally ill or permanently unconsciousness • You can also appoint a health care proxy

Basic Documents in an Estate Plan l Power of Attorney • Allows a person Basic Documents in an Estate Plan l Power of Attorney • Allows a person to conduct your business affairs if you are not present or not able • Acts of the attorney in fact are binding on the principal • Can be current or “springing” • Terminates at the death of the principal

Basic Documents in an Estate Plan l Will • Provides for the distribution of Basic Documents in an Estate Plan l Will • Provides for the distribution of property owned by the decedent at his death • Must be in writing and signed by the testator and two witnesses. Should be self-proving • Can be changed any time before testator’s death or incompetency

Non-Probate Estate l Non-probate estate • Jointly owned property • Retirement accounts • Generally, Non-Probate Estate l Non-probate estate • Jointly owned property • Retirement accounts • Generally, life insurance proceeds • Trust estate

Jointly Owned Property l Ownership • Joint with right of survivorship • Not affected Jointly Owned Property l Ownership • Joint with right of survivorship • Not affected by a Will • Not a probate asset • Tenants in common • Can be passed according to a Will • Probate asset l Potential problem

Will Contest l Who may write a will l Who may contest a will Will Contest l Who may write a will l Who may contest a will l What are the results of a will contest • 18 years of age, and • Of sound mind • Named in the will, and • Would take under rules of intestacy • Take the will as written, or • Distribute the estate as if there were no will

Provisions l Can you disinherit your spouse or children • Elective share of spouse Provisions l Can you disinherit your spouse or children • Elective share of spouse • The right of election of a surviving spouse and the rights of the surviving spouse to homestead allowance, exempt property and family allowance, or any of them, may be waived, wholly or partially, before or after marriage, by a written contract, agreement, or a waiver signed by the party waiving after fair disclosure

Advancements l Property which he gave in his lifetime to an heir is treated Advancements l Property which he gave in his lifetime to an heir is treated as an advancement against the latter's share of the estate only if declared in a contemporaneous writing by the decedent or acknowledged in writing by the heir to be an advancement

Revocation of a Will A will or any part thereof is revoked by a Revocation of a Will A will or any part thereof is revoked by a subsequent will which revokes the prior will or part expressly or by inconsistency l A will is revoked by being burned, torn, canceled, obliterated, or destroyed, with the intent and for the purpose of revoking it by the testator or by another person in his presence by his consent and direction l

Revocation by divorce l If after executing a will the testator is divorced or Revocation by divorce l If after executing a will the testator is divorced or his marriage annulled, the divorce or annulment revokes any disposition or appointment of property made by the will to the former spouse, any provision conferring a general or special power of appointment on the former spouse, and any nomination of the former spouse as executor, trustee, or guardian, unless the will expressly provides otherwise

Anti-lapse l If a devisee who is a grandparent or a lineal descendant of Anti-lapse l If a devisee who is a grandparent or a lineal descendant of a grandparent of the testator is dead at the time of execution of the will, fails to survive the testator, or is treated as if he predeceased the testator, the issue of the deceased devisee who survive the testator by five days take in place of the deceased devisee

Nonexoneration l A specific devise passes subject to any mortgage interest existing at the Nonexoneration l A specific devise passes subject to any mortgage interest existing at the date of death, without right of exoneration, regardless of a general directive in the will to pay debts

Limits of liability l No executor or administrator is liable, except in the case Limits of liability l No executor or administrator is liable, except in the case provided by section 43 -2 -62 (failure to give notice), beyond the amount of assets which have come to his hands or which have been lost, destroyed, wasted, injured, depreciated or not collected by want of diligence on his part or an abuse of his trust

Probate Estate Controlled by Will l Subject to probate court l Liable to pay Probate Estate Controlled by Will l Subject to probate court l Liable to pay debts l • Priority of claims • Homestead allowance ($6, 000) • Family allowance • Exempt property ($3, 500) • Funeral expenses • Administration expenses • Expenses of last sickness • Prior taxes • Debts due employees

Conclusion l With a little planning it should be possible to save the family Conclusion l With a little planning it should be possible to save the family farm • Tax planning can save all but the largest land holdings • A business entity or trust can provide a long-term management plan and prevent the forest from being subdivided • A will, power of attorney and advance directive are also part of the estate plan 50