The Strategist
3rd Quarter Supplement 1996 - Volume 3 Issue 4
In our last issue, we reviewed some of the
numerous tax law changes that will affect shareholders of subchapter S
corporations. To briefly review, beginning in 1997, subchapter S corporations
can have up to 75 shareholders. Additionally, a special type of trust referred
to as an ESBT which stands for Electing Small Business Trust would be allowed
to be a shareholder.
This type of trust could have multiple
potential beneficiaries with no requirement to distribute income. Again, this
takes place beginning January 1, 1997.
If you do not want to wait until January 1,
1997 to gift sub S stock to a trust but want the ability to accumulate the
after-tax income of the S distributions in the trust, it now appears that there
is a way as long as you set up the trust with just one beneficiary. How? Please
read on.
Recently, the IRS released a private letter
ruling (PLR 96 25031) that provides another alternative for existing owners of
subchapter S stock. In this circumstance, a husband and wife wanted to create
an irrevocable trust for the benefit of their adult child. The parents wanted
to transfer non-voting stock of an S corporation to the irrevocable trust. The
parents were also going to be the trustees of this trust. The parents would
give the adult child 30 days to withdraw any contribution to the trust (a
Crummey power). If the child did not withdraw the contribution to the trust,
the trustees (parents) would have the ability to pay income and principal to
the child as they saw fit (discretionary) with one caveat. The trust document
required the parents to pay out only to the child the income tax liability that
the child would face by being a subchapter S shareholder.
The taxpayer requested the IRS to rule
favorably on 4 key issues and the IRS did! First, the IRS ruled that the gift
to the trust would qualify for an annual gift tax exclusion. This is the
$10,000 that an individual can give to any individual every year without paying
a gift tax.
Second, the IRS ruled that the parents could
be the trustees of this irrevocable trust without having the assets included in
their estates. In other words, they could control the disposition on any income
generated by the trust other than the tax liability required to be paid out to
the adult child. Therefore, they could accumulate the funds and use this trust
as a form of an asset protection trust for the child.
In reaching this conclusion, the IRS
indicated that because the child could withdraw the contribution to the trust
and that the trust assets would be included in the child's estate at his death,
the assets would not be included in the parents' estate. Their reasoning behind
this was that the parents had relinquished all rights to the assets of the
trust.
Third, the IRS also indicated that the
parents, as trustees, could appoint their successor trustee without causing
estate inclusion of the trust in their estates. Previously, this was of great
concern to many people in the estate planning marketplace as to whether or not
this retained power to choose a trustee would cause estate inclusion of the
assets.
Finally, the IRS indicated that the adult
child would be considered the owner of the trust for estate purposes. By doing
this, the IRS also directs that this trust would be a qualified shareholder of
an S corporation. Remember, the trustees will only distribute the income tax
liability that the child incurs. In other words, if the trust had $1000 of sub
S income and the child is in the 40% tax bracket, the trustees would pay out
$400 which is the child's income tax liability. The trustees would retain the
remaining $600 in the trust for growth.
This is a break from the traditional
thinking that a subchapter S trust must pay out all income to its single
intended beneficiary. Beginning in 1997, a new trust called an ESBT can be a
shareholder with the requirement to pay out any income and there can be
multiple beneficiaries.
The IRS has also recently issued a private
letter ruling (PLR 96 36033) that has tremendous implications for estate
planning. This PLR acknowledges that split dollar can be done without a
corporation involved and, in fact, a private individual such as a family member
can take the place of the corporation's position.
A split dollar plan is generally derived
between an employer and an employee (usually the business owner). The
employee/owner usually will establish an irrevocable life insurance trust that
will enter into a split dollar agreement with the corporation whereby the
employer agrees to pay the vast majority of the cost of a life insurance policy
and the employee or, in this case, the irrevocable trust, agrees to pay the
lessor of a government PS 58 table or the actual insurance company's one year
term insurance cost.
The employee will gift, in cash, to the
irrevocable trust, the term insurance cost each year and the trust will
contribute this toward the policy premium. At the employee's death, the
corporation is repaid its premium advances in full with the balance of the
death benefit going to the irrevocable trust. Therefore, the employee's irrevocable
trust (outside of employee's estate) has received permanent insurance
protection for no more than term insurance costs. However, the employee must
gift the term insurance cost each year to the irrevocable trust.
In this PLR, the IRS has indicated to the
party requesting the PLR that a permissible split dollar plan can occur between
an irrevocable trust and a family member. Just as important, the IRS has also
indicated a way around potential on-going gifts of the term costs.
Let's review the basics of the PLR. Dad
established an irrevocable trust for the benefit of his child. Dad contributed
cash to this trust. Dad retained no incidence of ownership and named his
brother as trustee. The terms of the trust allow for discretionary income and
principal to the child during Dad's lifetime and, after Dad's death,
discretionary principal and income to Dad's wife or Dad's child The trustee
elected to purchase life insurance on Dad's life but wanted to split the
premiums with another party. The trustee and Mom entered into a split dollar
arrangement whereby the mother would contribute the majority of the premiums
and the trust would contribute only the term insurance costs each year. At
Dad's death, Mom would be repaid the greater of the premiums she advanced or
the cash surrender value of the policy. The trust would receive the balance of
the death benefit.
The person requesting the PLR asked whether
or not this would qualify as a split dollar arrangement and whether or not the
premiums paid by Mom would be considered a gift to the trust. Mom has not
decreased her estate since she will be repaid at the time of Dad's death.
However, it does create an opportunity for Mom to make a loan to the
irrevocable trust for insurance that will be outside of her estate and outside
of her husband's (Dad's) estate. Dad would have the ability to pre-fund
multiple years of the term insurance costs up front with a single gift. The
earnings on the single gift can extend the number of years that the deposited
dollars will provide for the term insurance. Again, only Dad's initial cash
gift to the trust counts as a gift if all of the on-going PS 58 term costs have
been paid by the trust from the original principal received by gift from Dad.
The IRS indicated that this arrangement is
similar to split dollar arrangements that they have favorably ruled upon with
corporations and felt as though it was a variation of a split dollar plan.
Secondly, the IRS indicated that the premium payments (the advancements by Mom)
would not be considered an additional gift to the irrevocable trust by Mom.
Why is this such great news for our readers?
The answer is several-fold. First, many of our readers have sold their
businesses and have terminated their split dollar agreements. Now there is
another opportunity to enter into split dollar agreements using the same
scenario described in this PLR, only Dad's initial gift to the trust would be a
gift. None of Mom's payments would be gifts to the trust.
Second, many of our readers have chosen a
single level taxation system for their corporations such as a sub S or an LLC.
Many times, individuals that have elected pass-through corporate tax
structures, such as the sub S or LLC, do not enter into split dollar agreements
since it can potentially create a double taxation on the term costs. This PLR
creates an opportunity to enter into split dollar agreements with family
members without double taxation.
One interesting twist -- what if Mom's
estate plan called for her assets to be left to the irrevocable trust created
by Dad at Mom's death? If Mom pre-deceased Dad, the premium advancements that
she has made are an estate asset (receivable) and would be left to the
irrevocable trust. Under this scenario, the irrevocable trust could cancel the
split dollar agreement since the trust would technically owe itself the premium
advancement. There are tremendous planning opportunities with this PLR.
It is important to note that private letter
rulings are not authority and are only applicable to the taxpayer that actually
requested the ruling. However, it does provide guidance on what the IRS
believes and what their thought patterns are.
The
Wealth Transfer Group, Inc. is not engaged in the practice of law or accounting
nor are any of its employees, representatives, or agents. Tax and legal advice
should be obtained from qualified personnel.
(c) 1996 The Wealth Transfer Group, Inc.
283 Cranes Roost Boulevard, Suite 145, Altamonte Springs, Florida, 32701 (407)
339-5787
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