Keith,

What are the advantages of putting personal real estate (first or second homes) into trusts or LLC’s other than limiting potential liability issues?

Thanks,

Bob

BOB,

Great question. First, let’s distinguish between Trusts and LLCs or any other form of business entity. Placing a property into a REVOCABLE living trust (RLT) has absolutely NO affect on your personal liability. RLT’s are pass-through entities used for estate planning purposes, primarily to avoid probate, but also to provide for the family in the event one or both of the testators (creators of the trust) become incapacitated.

RLTs are tremendous estate planning tools, and may also be used to establish by-pass trusts that help preserve the estate tax exemption for the first to die while giving a surviving spouse the benefit of income from the protected amount, and access to the corpus under defined circumstances. But they do NOT protect you from liability.

Placing property into an IRREVOCABLE trust CAN protect you from liability. You might establish an irrevocable trust, and put investments into it (other than insurance, which process is governed by a different set of rules and is facilitated by a different kind of irrevocable trust known as an irrevocable life insurance trust, or “ILIT”), while naming yourself as the trustee for the benefit of the trust’s named beneficiaries. The beneficiaries must be people other than yourself.

If you create an allegedly “irrevocable” trust, but name yourself as anything other than an income beneficiary, or give yourself control of the trust assets for your own use, then you’ve not created an “irrevocable” trust at all. Instead you created an “settlor retained trust”. This trust will be ignored for liability purposes in all but a few jurisdictions.

But you didn’t ask about liability, you asked about the other benefits of placing property into a trust or LLC.

Again, assuming the trust is genuinely irrevocable, then many of the same general rules apply whether the property is in a trust or an LLC.

Typically, wealthy investors will gift property into either an irrevocable trust, an LLC, or into a family limited partnership (FLP). They will then appoint themselves as trustees of the trust, or managers of the LLC or FLP, while naming family members as beneficiaries if using a trust, or as shareholders if using an LLC or FLP. But as trustee or manager, you work FOR the beneficiaries or the shareholders. It’s their property!

In addition to limiting liability, both approaches have these advantages:

1. You freeze the value of the gifted assets in your estate. Appreciation inures to the benefit of the beneficiaries or shareholders. This can significantly reduce your estate tax liability.

2. You continue to maintain control of the assets, and may even pay yourself for managing the assets. But the assets belong to the beneficiaries or the shareholders. In the case of trusts, you may also create an income interest for yourself, but this will generally reduce the value of the gift; and since you may be trying to get as many assets out of your taxable estate as possible, this may not be desirable.

3. In the case of LLCs and FLPs, you can enjoy substantial valuation discounts due to the discount available for minority interests.

Often, Mom and Dad will start with a large percentage ownership in, say, an LLC. They’ll put their strip mall in it. Then, using their annual exclusion gift amount and/or their lifetime estate tax exemption amount, they will gradually gift shares in the LLC to their kids. However, even though the property they put into the LLC might have been worth, say $1,000,000 when they made the gift, and even though may have appreciated to, say, $2,000,000, each time you give the kids more shares you may be able to claim that the gift is worth a small fraction of your original contributed amount. This is made possible by the fiction of “minority discounts” — the idea that since the property is now encumbered by the claims of other shareholders, a $1 minority interest held by an adult child is not really worth $1.

There are also disadvantages to this approach:

1. It is complicated. ONLY do this with the guidance of an experienced estate planning attorney. And find an attorney who is NOT looking for a litigation opportunity with the IRS after you die!

2. As long as capital gains rates stay low, it MAY not be worth the effort, expense and paperwork, long term. This depends heavily on the size of your estate, the nature of the property, and many other factors; and perhaps most importantly…

3. When you die, neither your spouse or your kids will enjoy a stepped-up date-of-death presumed tax-cost basis on any portion of these potentially highly appreciated assets you don’t own. They will only receive a stepped-up date-of-death basis on that potentially small portion of the LLC or FLP you still own. They will be stuck paying tax, once the assets are eventually sold, based on the value of the original gifts to the LLC or FLP. As you can see, the “minority discount” claim cuts both ways, and they will have a hard time claiming a fair market value stepped-up basis on the shares if you claimed minority discounts when you made gifts of shares to the kids.

Finally, keep in mind that estate planning attorneys and the IRS can — and frequently have — overcomplicated these issues beyond recognition.

Obviously, if your estate planning attorney demonstrates how you will save hundreds of thousands — if not millions — of dollars in taxes with these techniques, and if he or she ALSO adequately demonstrates that there are no simpler solutions available, these estate planning techniques are well worth a look.

Thanks for your question, Bob, and thanks for following The Global Adventure!

— Keith

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