The Legal Intelligencer Blog

A Blog That Mentions Both Trusts and Estates Law and Hooters

By Robert H. Louis

A recent news report indicates that an effort will be made to sell or recapitalize the restaurant chain Hooters, as a result of a family dispute over the will of the majority owner of the business.  (I’ve never visited one of these restaurants, but I see that their ads feature a picture of an owl, so I assume they have a library-like atmosphere.)  The report illustrates several issues in the operation of family businesses, and how a failure to plan and to consider the effect of trusts and estates law on such businesses can lead to an unfortunate result.

Apparently, the decedent and some other businessmen purchased control of the chain some years ago, and the decedent was the majority owner.  In addition, the decedent had married for a second time, and had a son from his first marriage who was actively involved in the business, a much younger second wife, and a young child from the second marriage. His will gave 30% of the estate to each of those children, another 10% to Clemson University (carrying on the decedent’s long years of philanthropic giving), and other amounts to friends and associates. He left $20,000,000 to his wife, payable $1,000,000 per year.  The decedent and his wife, who were not living together at the time of his death, were residents of South Carolina, which has a provision in its law allowing a surviving spouse to elect to “take against” the will to the extent of one third of the decedent’s estate. Pennsylvania law has a similar provision. The widow made such an election, and the decedent’s older child challenged this election, in part because he contended it was unconstitutional. After some legal wrangling, the parties settled for an undisclosed sum, and now the older child is looking at various options to either carry on the business or sell it.

It seems clear, from several reports on this case, that the decedent wanted the older child to run the business.  He had retired from active involvement and placed his older child in charge.  However, he made no arrangements other than in his will for the transfer of the business to that child.  This was clearly a mistake.  Planning for the business transition could have been completed before the decedent’s death in ways that could have protected the older child’s management of the business.  The second wife should have been asked to sign a prenuptial agreement, very common these days, especially in second marriages, to limit her rights against the estate.  The wife could also have been provided for through insurance or other planning techniques. 

It is possible that these possibilities were considered by the decedent and didn’t work. But in the world of family businesses, a much more common occurrence is to defer consideration of family business issues, in no small part because they require difficult conversations. It’s easier to do nothing and hope that “things” sort themselves out.  But that doesn’t often happen. An important service that lawyers can offer to business clients is to help them address these issues and, if other types of professionals are needed to facilitate the process, to recommend hiring such people. 

Robert H. Louis is a partner and co-chairman of the personal wealth, estates and trusts department at Saul Ewing. His practice includes estate, tax and retirement planning for individuals and closely held businesses. He is a fellow of the American College of Tax Counsel and a graduate of the Wharton School and the Harvard Law School. Louis can be reached at [email protected] and 215-972-7155.

Another Possible Solution to Estate Tax Problem

Very recent discussions in Washington have resulted in a proposal that resolves the estate tax issue and avoids litigation on constitutionality.

Congress is expected to reenact the estate tax at some point, although the exact date is unclear.  Some commentators have suggested that no action may be taken in all of 2010, which would result, under the law enacted in 2001, in a return to a graduated tax system with rates up to 55 percent and a $1 million exemption.

But here is a proposal that is being discussed by some Democrats in D.C.: The estate tax would be reenacted through 2011 with a 45 percent rate and a $3.5 million exemption.  But for those who died between Jan. 1, 2010, and the date the new law is passed, there would be a choice: You could be taxed under the reenacted law (45 percent, $3.5 million) or you could pay no estate tax and have carryover basis for the assets owned by the decedent; that is, there would be no step-up in basis at death.  Thus, for those decedents, there could be a determination of which taxation method produces less tax and less complexity.

That idea seems to avoid the possibility of litigation challenging the retroactive enactment of the estate tax.  If the tax is simply reenacted in a few weeks, retroactive to Jan. 1, there is sure to be litigation challenging its constitutionality, and the outcome is not clear.  Further, such litigation could drag on for years, resulting in uncertainty as to how estates are to be administered for a long period of time.  The option technique permits decedents’ representatives to choose how to be taxed, so they would have nothing to complain about.

Robert H. Louis
Saul Ewing
http://saul.com

2010 Brings Temporary Estate-Tax-Free Period

In the week since the dawning of the (temporarily) estate-tax-free world, it has now been suggested that Congress will not try to re-enact the federal estate tax retroactive to the beginning of the year. There was considerable uncertainty expressed as to whether Congress could do such a thing.  If they did so, there would surely be litigation challenging such action, and that would have resulted in delay in settling estates.  The effect of leaving the estate tax in abeyance for a period of time, which might continue for the entire year, is that anyone dying during the period would have no estate tax assessed on his or her estate.  Of course, very few people have enough assets to be subject to the estate tax under the $3.5 million exemption in effect in 2009.  But the news for families of those who die during the lacuna period is not all good, because of the carryover basis problem.

If the assets of a decedent are not subject to estate tax, then the basis of those assets is not automatically stepped up to date of death value.  There's an exception to this rule, as there is to everything in the Internal Revenue Code. A certain amount of assets may be stepped, more if they pass to a surviving spouse.  But this requires additional work to determine which assets should be chosen for step-up.  And for those assets not stepped up, it will be necessary to keep records of the basis of the asset when it was owned by the decedent.  That could be difficult for assets acquired by the decedent many years earlier.  And it has the tax effect of subjecting those assets to capital gains tax upon sale that would have been avoided if all assets had been stepped up to date of death value.

But there's another wrinkle.  Many wills that were written based on the existence of the federal estate tax might not work as intended if there is no such tax in effect.  For example, many wills have been written in this way: Give my surviving spouse the smallest amount necessary to reduce the estate tax as low as possible and give the balance to a trust for my family.  When the tax was in effect, that meant that the exemption amount would go into the trust, and the balance would pass to the spouse, outright or in another trust.  But now, the amount that must pass to the trust to minimize estate taxes is zero, so nothing would be allocated to the spouse.  The spouse might benefit from the remaining trust, but only if the will is written so that the spouse might benefit from that trust, and not all wills are so written, particularly those where there is a second marriage.  So this change in the will might result in estate plans not working as intended, possibly leading to surviving spouse electing to take a statutory share in lieu of the will provisions.  And lawyers may be called to account if they haven't advised clients of the effect of the change in the law, and the possibility of amending wills to correct the problem.  Our firm has been contacted by our insurance carrier to advise us of our responsibilities toward clients as a result of the lapse in the tax.  So the failure to extend the tax has possible effects beyond the simple freedom from estate tax for those who die before the tax is re-imposed.

It’s a Holiday Miracle

Congress has fallen below even the lowest expectations of tax practitioners.  It’s like a (bad) dream come true.

For the past eight years, I’ve been describing our estate tax system to clients: We’ll have gradually lowering rates, and the exemption will eventually rise to $3.5 million.  Then, if you can believe it, there will be one year, 2010, when the tax will disappear.  The next year, the tax will reappear, at the higher rates and lower exemption that existed before the law was changed.  Then, I would explain that Congress would of course have to fix the law because that made no sense.  We would laugh, and I would send them a bill.

But time passed and the law wasn’t fixed.  Congress flirted with repeal of the estate tax, but never reached that point.  It was assumed that they would do something to avoid this strange sequence of tax law changes, which originated in artificial budget constraints.  There was some continued grumbling about repeal, mostly from people trying to get the attention of wealthy donors.  Earlier in this month, it appeared that there would be a one-year extension of the current law ($3.5 million exemption, 45 percent tax rate), then maybe an extension of a few months.  Now, the effort to extend the law has been abandoned for the year, and the estate tax is scheduled to be reduced to zero in 2010. 

Leaders in Congress promise that the law will be changed early in the year.  But that means that the law would have to be amended retroactively to the first of the year.  Otherwise, the lucky people who die in the first week (or actually their families) would have a windfall for no particular reason.  Congress has the power to pass tax laws on a retroactive basis, at least back to the beginning of the year, but every time this happens, there are lawsuits, and we can expect those again, but it’s likely that a retroactive change would be upheld.

The absence of an estate tax in 2010 has another consequence.  Under the current law, when someone dies, his or her assets are stepped up in basis to their date of death value, which is a valuable tax benefit.  Without an estate tax, assets won’t be stepped up.  Instead, those who inherit will carry over the basis the decedent had, which will add to the complexity of the tax law administration and increase tax liabilities on the heirs, in many cases more than the estate tax would have done.  When carryover basis was added to the law in the 1970s, it was so complicated that it had to be repealed.  Let’s hope that a new year will bring a resolution of this problem.

Robert H. Louis

Congress Might Vote on Estate Tax, or Might Not

The Democrats are divided into their usual factions, and the Republicans aren’t sure whom they represent.

It’s possible that the House will vote for an extension of the current estate tax rates shortly, but as usual, no one is sure until it actually happens.  The Democratic leadership, and President Obama, would like to extend the current $3.5 million (per person) exemption indefinitely.  Some Democrats want to reduce the exemption, while others want to increase it to $5 million; and others want to do that and index it for inflation (in case we ever have any).

The Republicans are divided. Business owners and their lobbyists like the $5 million exemption, especially with indexing, and the reduction to 35 percent in the flat rate. A $5 million exemption means that a husband and wife could, with some planning, pass $10 million of assets free of tax.  That would eliminate the tax for nearly everyone.  But there are others still holding out for complete repeal of the tax, which benefits the very rich, or a reduction in the rate to 15 percent, which would be far more costly that the Democratic proposal, at a time of exploding deficits.  The Republicans are divided, in a sense, between the Main Street party, representing the owners of small to midsized businesses, and the wealthy contributors for whom a $5 million exemption is pocket change. 

It’s also possible that no change in the law will occur, which means that 2010 will be a year of no estate tax.  This would be a nonsensical and fiscally irresponsible result.  Trust and estate practitioners, who seem to be represented in both parties, would like to see certainty, so that efficient planning could take place.  It certainly won’t happen this year, but a sensible change to the estate and gift tax, one that encourages business growth and the passage of wealth to younger generations, might include the following: 

• An exemption of at least $3.5 million rising fairly soon to $5 million, and indexed to inflation.
• A rate that is settled on, either 35 or 45 percent, or perhaps 35 percent up to $20 million and 45 percent thereafter.
• An expansion of the gift tax exemption from $1 million to the amount of the estate tax exemption, to promote lifetime gifts.
• Portability of the estate tax exemption, so that if one spouse can’t use the full amount, the surviving spouse can use the difference.

Family Business Planning in High Gear

The combination of continued low interest rates, a struggling economy and uncertainty about taxes makes planning important right now.

IRS interest rates used in valuing various kinds of gifting techniques fell again in November, making the use of Grantor Retained Annuity Trusts, for example, more valuable. And compared to the situation a few years ago, they are far more effective. Many commentators suggest that interest rates will begin to rise, and it's difficult to see how they could go any lower. Eventually, we'll return to an interest rate regime that is closer to normal, if we still know what normal is. The hope is that rates don't fly past normal to the levels seen in the late 1970s. But for now, methods of transferring business interests, which are generally done within family units, are more efficient with the current historic low rates.

Valuations of business interests are also low right now. Few businesses have escaped the economic downturn. A valuation done now will certainly emphasize the most recent past, and that will lead to lower valuations. Lower valuations mean that more business interests can be transferred within the constraints of the limits imposed by the federal gift tax. Lower interest rates also lead to lower valuations. Many believe that the recession has ended, and that there is reason for belief that next year will bring a strong recovery. That is, of course, similar to what President Hoover said in 1930, but perhaps history won't repeat. But right now, for most businesses, valuations have probably hit lows that won't be seen again for many years. So healthy businesses suffering a cyclical downturn are ideal candidates for transfers right now.

The bizarre result enacted into the federal estate tax law, repeal for 2010 and then a return of the tax at higher rates and a lower exemption in 2011, is now about six weeks away. No one believed that this taxation scheme made any sense, or that Congress wouldn't fix it long before now. We now hear discussion of a one-year fix in the statute, continuing the 2009 law into 2010. But that needs to happen soon. And, although there have been some general proposals regarding changes in the federal estate, gift and income tax law, we have yet to see anything really concrete from the administration. It might be that change is coming in 2010, but for now we have the existing law, with many good planning techniques, intact. So, for a third reason, balancing the certainty of current law against the uncertain future, now is the time for family business planning. 

Robert H. Louis
Saul Ewing
http://saul.com

Effort to Repeal Federal Estate Tax Has Apparently Ended

A recent letter sent to Congress indicates an end to business support for repeal.

At one point, a few years ago, it looked like repeal of the Federal Estate Tax might occur. Or at least it was discussed frequently. Cynical folks might suggest that the tax wouldn't be repealed because then politicians couldn't ask for contributions to continue the struggle. But in any case, the arrival of Hurricane Katrina seemed to derail talk of repeal, since that disaster showed that we might need a little more federal revenue to pay for natural disasters and the occasional war.

Nevertheless, talk continued for several years of the merits of repeal. Then, the discussion seemed to morph into a much lower rate, such as 15 percent, and a much higher exemption. A higher exemption helps more business people and farmers escape the tax, while a lower rate benefits those with very large estates, for whom the higher exemption isn't very helpful. And it was the latter group that seemed to be making the most contributions. After a while, it seemed like a symbolic effort, much like the idea of a constitutional amendment to require a balanced budget.

Just recently, the discussion took a different turn. A coalition calling itself the Family Business Estate Tax Coalition sent a letter to members of Congress and senators, suggesting enactment of a 35 percent tax (compared to the current rate of 45 percent) and an exemption of $5 million (compared to the current $3.5 million). The coalition includes many business associations, such as the National Association of Manufacturers. One of the important reasons given for this proposal was that it replaced the current crazy quilt scheme of taxation with the certainty of a permanent rate and exemption. It's not clear that this proposal will be enacted, but it seems to signal a move toward a consensus on the estate tax, that it will remain in effect but cover only those with very significant wealth who have taken no steps during life to minimize the tax bite.

Robert H. Louis

What Philadelphia Has Plenty Of

It's family businesses. Actually, it's a worldwide phenomenon.

Throughout the world, family ownership is the predominant form of business operation. This is true in India, Australia, Germany and, of course, in the United States. The Philadelphia area, including New Jersey, Delaware and southeastern Pennsylvania, has many thousands of family-owned businesses. They are the primary engine of business and employment growth in this region.

Family-owned businesses offer many advantages. A business school professor told a client's son who was in one of his classes: "There's nothing like a family business." But there are challenges in family-owned businesses. The ability of a family-owned business to continue for succeeding generations is dependent upon finding the right leadership qualities in the next generation and also navigating family relationships to minimize discord.

There are many areas of family business that benefit from the help of lawyers, as well as accountants, financial advisers and business planning consultants. The services that lawyers offer include business counseling, gift and estate planning, buy-sell agreements, retirement planning and other assistance in helping the older generation feel secure in turning over the business and the younger generation feel confident in taking over.

One organization that helps lawyers and others to understand family business issues and to serve the needs of business owners is the Family Firm Institute. This national and international organization provides books, courses and Web site information to help business advisers throughout the world understand and guide business owners. A group of lawyers, accountants, financial advisers, psychologists and other consultants has decided to establish a chapter of FFI in the Philadelphia area, and FFI has approved the formation of the Mid-Atlantic Chapter. We plan numerous kinds of programs in Pennsylvania, New Jersey and elsewhere in the coming year. If you would like more information about the new chapter of FFI, contact me at [email protected].

Let’s Take Grandpa on a Roller Coaster

Some fun, eh, Grandpa? Grandpa?

We are now within a few months of the effective date of perhaps the craziest tax scheme ever passed by Congress (although there are many competitors for that title).  Beginning Jan.1, 2010, there will be no federal estate tax due with respect to decedents dying on or after that date, until the end of the year.  Then, when 2011 arrives, the tax is reinstated, but the exemption falls back to $1 million and the maximum rate rises to 55 percent.  So, under the current tax scheme, people who die next year will, in some sense, be performing a selfless financial act for their families.  Or, as suggested by the title, they might be encouraged.

It sounds funny, but that’s the method of taxation passed by the Congress and signed by the president in 2001.  Everyone assumed that the law would be changed long before 2010, but that date is fast approaching.  All that needs to happen for this bizarre tax situation to come into effect is that the Congress does nothing.  And, as we have seen, that’s one of their specialties.

Numerous proposals have been made to remedy this situation.  Those proposals include: reducing the exemption to $2 million for an indefinite period; increasing the exemption to $5 million; allowing a surviving spouse to use any portion of the exemption not used at the first death; and re-unifying the estate and gift taxes, so that people could give away the full amount of the estate tax exemption during life, rather than being limited to $1 million.  The president has recommended making the $3.5 million exemption and 45 percent rate apply for 2010 and future years.

It’s still very likely that the law will be changed by Dec. 31.  In the meantime, the only sensible planning assumption can be that the tax will remain in effect, and probably with the exemption and rate now in effect.  But, while we’re waiting to see what happens, this is an ideal time to do lifetime planning.  Interest rates used by the IRS in valuing various kinds of transfers remain low, and asset values have also remained at low levels.  For those interested in transferring homes or businesses, this is the time to act.

Robert H. Louis
Saul Ewing
http://saul.com

Criminals I Have Known

Not the high-class kind with a mask and a gun, but the financial type.

Much has been written about the psychology of people like Bernard Madoff, who apparently can invite people to invest with them in the knowledge that their money will eventually disappear. None of my clients dealt with Madoff, but I have met with advisers who, at a later date, were accused of having used client funds for their personal expenses. The two I have in mind presented themselves as intelligent and savvy investment advisers. I'm not sure they intended to convert funds from the outset, but it's alleged that that was their eventual course. Both spoke knowledgeably about the market, in a way that impressed less sophisticated investors, which is just about all of us. This came to mind over the weekend. On a flight from Munich to Philadelphia, I was the third-party beneficiary of a passenger who spent about three hours telling the person next to him that his adviser was the greatest and had exactly predicted the market downturn. (For the record, I have one wealthy client who, on his own, correctly anticipated the market decline and suffered no losses. I'm fairly sure that he finished high school.)

What is the lawyer's role in dealing with investment advisers? It's certainly not to give investment advice to the client, but it's also not to remain silent. I have written before that these uncertain times have led many to consider investing through large organizations, because of their deep pockets and internal protective procedures. Others prefer individual or small firm guidance. In either case, it is the lawyer's task to ensure that all of the necessary paperwork has been completed and copies given to the client. It's important to remind the client to have regular meetings to review investment strategies and results. It's also appropriate, if the adviser is achieving investment results that are significantly better than others are achieving, to ask how this is being done. That is, due diligence. In some cases, it might be advisable to bring in another adviser, just to review what the first one has done. I once suggested this to the board of an industry pension plan, because its adviser had done extremely well with investments no one on the board could understand, and unwitting uncovered a massive fraud and theft by the adviser. So, the lawyer is not an investment adviser, but he or she should be asking the client if steps are being taken to ensure that what is promised or advertised is in fact happening.

This is a little off the point, but my recent travels also took me to Vilnius, the capital of Lithuania, a country where the protection of rights by lawyers was, until recent years, subject to the control of an overbearing Communist regime. I had an opportunity to visit a KGB prison, where I saw cells used for torturing political opponents. The Lithuanians have opened these cells to public view, so that they will not forget the horror of living under a regime that condoned and practiced torture.

Robert H. Louis
Saul Ewing
http://saul.com