Private Client Services Update – A Case Study for Use of §1031 Exchange in an Estate Planning Context
The following case illustrates why an estate planner should also have a good working knowledge of income tax transactions and partnership/LLC mechanics.
Dad died many years ago. Mom inherited a large tract of land (presently unproductive, but developable) with a low cost basis and worth about $5,000,000. Mom has other assets and income, however she has an income tax problem with this land and an estate tax problem. She has two children, Alice and Bob.
Mom wants to sell the land and diversify into other income producing properties, ultimately for her children. Fortunately, the children get along with each other.
A buyer has offered to purchase the land for cash. In order to defer (and perhaps eliminate) the income tax, Mom arranges for a like-kind exchange into two separate properties. However, the target properties will cost more than the $5,000,000 proceeds from the sale, so debt financing on each property will be necessary. The Lender requires each target property be held in a separate SPE entity for liability, risk and bankruptcy purposes.
The general rule under IRC §1031 is that the target properties must be taken in the name of the selling taxpayer. However, a single member LLC is a disregarded entity under §7701. The LLC property is treated as owned directly by the single member. Mom can take title to the two separate target properties in two separate LLCs and still qualify for §1031 tax deferred treatment.
The target properties are Alpha Apartments and Beta Building.
Mom closes on the §1031 exchange and then owns two separate entities, Alpha Apartments, LLC and Beta Building, LLC, each with a separate target property, and income tax has been deferred.
Mom must continue to hold the target properties for a period of time (perhaps as little as a year) in order to meet the post-acquisition “held for investment” requirement under §1031.
A year passes and Mom wants to transfer some interests in the properties to Alice and Bob to give them management and operating experience in the properties. She had provided for the Lender’s consent to family transfers in the loan documents.
Mom amends the LLC Operating Agreements to provide for 2 Voting Shares and 98 Non-Voting Shares for each LLC.
Mom either sells or gifts 1 Voting Share (each lacking voting control) of each LLC to Alice and Bob. The transfer value of each Share has a discounted value for a lack of voting control under §1001 and/or §2512.
Mom reports the transfers on her income tax return or gift tax return, as the case may be, and fully complies with the valuation disclosure rules under the §6501(c)(9) Regulations so that the applicable statute of limitations period on future revaluing the transfers will begin to run.
The children begin active management of the properties.
Mom’s Last Will and Testament now leaves the 98 Non-Voting Shares in Alpha Apartments, LLC to Alice and the 98 Non-Voting shares in Beta Building, LLC to Bob.
Upon Mom’s passing, her estate tax value under §2031 of all of the Non-Voting Shares will be discounted in value for lack of voting as well as lack of marketability. There will be a step-up in income tax basis to this extent under §1014 and elimination of the income tax on that value.
Alice and Bob will form a voting agreement to allow Alice to control Alpha Apartments, LLC and Bob to control Beta Building, LLC. Alice and Bob also each grant the other a call option to purchase the Voting Share of the LLC with respect to which the Non-Voting Shares are owned, so final separation may later be achieved by either party.
By having a working knowledge of income tax, partnership and procedural provisions of the tax code, in addition to the estate and gift tax provisions, Mom’s well-informed estate planner has provided for the transfer of Mom’s property to her children, saving income, estate and gift tax costs for the family.
R. Braxton Hill is a partner with Kaufman & Canoles, where his practice includes advising clients on tax-advantaged strategies for investments, acquisitions, mergers, tax-deferred exchanges, reorganizations and tax accounting for operations. His practice also includes business succession and estate planning for investors and business owners. Braxton’s client base is mainly closely-held corporations, partnerships, LLCs, estates and trusts. The clients are both domestic and foreign, advising US investors on overseas transactions and foreign nationals on US transactions. Braxton has a special emphasis on tax controversies and IRS cases in tax administrative examinations, collection, appeals and tax litigation matters in federal and state courts. He can be reached at (757) 624-3106 or email@example.com.’
The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2023.