Real Estate Advisor, January 2012By Harry Moehringer | January 10, 2012 | Download PDF
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Succession planning can be daunting. A grantor retained annuity trust (GRAT) can help. It lets a business owner minimize gift and estate tax liability associated with transferring ownership interests while retaining an income stream for a specified period of time.
Along with selecting the right family member or other individual(s) to carry on the business, you must weigh a variety of tax and financial planning issues. The use of a grantor retained annuity trust (GRAT) by a closely held business owner is one way to help reduce the tax burden.
A GRAT can help minimize gift and estate tax liability associated with transferring ownership interests, while at the same time retaining an income stream for a specified period. In the current economic environment- where the lifetime gift tax exemption is $5 million and the value of your business might be lower than it was a few years ago, a GRAT can be quite tax-effective.
The Nuts and Bolts
A GRAT is an irrevocable trust funded by a one-time contribution of assets by the “grantor.” For example, if you’re the owner of a real estate development company, you can transfer some or all of your ownership interests in the business to the GRAT. The GRAT pays the grantor an annuity for a specific term.
The amount of the annuity payment is a fixed percentage of the grantor’s initial contribution or a fixed dollar amount and it must be paid at least annually. The grantor maintains the right to the annuity payments regardless of how much income the trust actually produces. When the GRAT term expires, the assets remaining in the trust (known as the “remainder”) are transferred to the designated beneficiaries.
For gift tax purposes, the value of the gift tax is determined when the GRAT is funded based on the value of the beneficiaries’ remainder interest. The remainder interest’s value is based on the appraised value of the property transferred to the GRAT, the term of years of the GRAT and an interest rate - known as the IRS § 7520 rate- in effect at the time of the GRAT’s creation. An asset such as an ownership interest in a closely held real estate business (or any asset other than publicly traded stock), must undergo a valuation before the § 7520 rate can be applied to calculate the remainder interest’s value.
When the § 7520 interest rate is low - as it has been recently- and the trust assets are able to generate a total return that is greater than the § 7520 interest rate, the assets will be worth more when the trust terminates than the remainder interest’s gift tax value.At the termination of the trust, any asset appreciation in excess of the initial value of the asset contributed, passes to the beneficiaries free of gift and estate taxes. Considering that the Sec. 7520 rate has been at 2% or less for a while, many GRATs have outperformed and passed substantial wealth to the next generation.
Furthermore, with the lifetime gift tax exemption increased from $1 million to $5 million for 2011 and 2012, your gift tax obligation when funding a GRAT may be significantly lower than it would have been in the past- or stands to be in 2013- when the exemptiondrops back down to $1 million, absent additional Congressional action.
In addition, if your business’ value is currently lower than it has been in the past, the GRAT contribution may generate a lower value for gift tax purposes. And GRATs work particularly well for interests in closely held businesses because valuation discounts can reduce a gift’s value for tax purposes even further. If you make a gift of less than 50% of the interests in your company there is a further discount due to minority interest. This is what is called “leveraging”.
The grantor of the GRAT must report all of the income, gains and losses from the trust assets on his/her individual income tax return. Paying income tax on the trust asset income and gains is actually beneficial for estate planning purposes. Why? By paying the tax, the Grantor’s estate is further reduced (rather than the GRAT paying taxes), and you preserve the trust’s assets for the beneficiaries — essentially making additional tax-free gifts to them — and further reducing the size of your taxable estate. Please note that over the term of the Trust, the annuity stream will essentially return to the grantor the value of what was contributed. It is the growth over the initial value- plus future growth after the Trust terminates- that is transferred to the next generation.
While the IRS accepts GRATs as valid vehicles for transferring assets, it does impose some rules on the trust instrument used to create a GRAT. The instrument must prohibit:
- Additional contributions to the GRAT,
- Commutation (prepayment of the grantor’s annuity interest by the trustee), and
- Payments to benefit anyone other than the grantor before the grantor’s retained interest expires.
Moreover, issuing a note, other debt instrument, option or similar financial arrangement to satisfy the annuity obligation is not allowed.
If a GRAT sounds right for you, now is the time to contact your tax advisor. First, you can potentially take advantage of a low business value, a low § 7520 interest rate and a high gift tax exemption.
Second, Congress has introduced several bills that would limit the benefits of GRATs by requiring a minimum term of 10 years. Thus, the benefit of transferring the appreciation out of the grantor’s estate may be reduced or lost if this provision is repealed. It’s likely that any successful legislation would apply only prospectively, though, leaving existing GRATs intact.
GRATs, GRUTs and GRITs, Oh My!
GRATs aren’t the only type of grantor trusts available for estate planning. You might also want to consider a grantor retained unitrust (GRUT) or grantor retained income trust (GRIT). Like a GRAT, both are irrevocable trusts created by the transfer of assets and followed by the gift of remainder interests. However, there are some key differences.
When you create a GRUT (Grantor Retained UniTrust), you retain an annual right to receive a fixed percentage of the net fair market value (FMV) of the trust assets, determined on an annual basis, for a specified term. If the FMV increases, the amount of your payment also increases. Just as with a GRAT, if you survive the term, the remaining value of the trust passes to the named beneficiaries. The one drawback is that the fair market value of the Trust assets must be revalued every year. This can be impractical for a closely held business and possibly expensive.
With a GRIT (Grantor Retained Income Trust), you retain the right to receive all of the income the trust generates for either 1) the earlier of a specified term or at your death, or 2) a specified term. If you outlive the specified term, any principal left in the trust passes to the beneficiaries named in the trust instrument. However, the beneficiaries can’t be members of your family. It should be noted that “family members” does not include nieces and nephews so that if they are to be your heirs, a GRIT may work better for you.
Under recently released IRS Revenue Procedure 2011-34, real estate professionals can now more easily make late elections to treat all interests in rental real estate as a single rental real estate activity. What does this mean to you? The election can help you retroactively meet material participation requirements and potentially deduct losses.
Why It Matters
The Internal Revenue Code (IRC) generally allows you to claim passive-activity losses only against income from other passive activities. If your passive losses exceed your passive income for the year, you can carry the losses forward until you either have enough passive income to absorb them or you dispose of the activity, in which case you’re generally allowed to deduct the losses against nonpassive income.
“Passive activity” is defined as any trade or business in which the taxpayer doesn’t participate on a regular, continuous and substantial basis (also known as “material participation”). Rental real estate activities are usually considered passive activities regardless of whether you materially participate — unless you qualify as a real estate professional. Then rental activities are treated as a trade or business, and losses from the activity aren’t considered passive, so you can deduct them against nonpassive income.
The Stumbling Block
A taxpayer qualifies as a real estate professional by satisfying two requirements. First, more than 50% of the personal services the taxpayer performs in trades or businesses must be performed in real property trades or businesses in which the taxpayer materially participates.Second, during the tax year the taxpayer must perform more than 750 hours of services in real property trades or businesses in which he or she materially participates.
Under the IRC, a taxpayer’s interests in rental real estate generally will be treated as separate activities when determining whether the taxpayer materially participates in each rental real estate activity — unless he or she elects to treat all interests in rental real estate as a single rental real estate activity. To make this election, the taxpayer must file a statement with specific information attached to your income tax return. Taxpayers failing to make the election on their tax returns can seek an extension of up to six months by obtaining a letter ruling from the IRS. However, this is a burdensome process which can take months from start to finish.
An Easier Way to Make Late Elections Effective
The IRS has now outlined special procedures, in lieu of the burdensome letter ruling procedure, for making a late election. To be eligible, a taxpayer must show the following:
- He or she failed to make the election solely because of failure to timely meet the election requirements.
- He or she filed income tax returns consistent with having made an election. That is,
- The returns must have been filed “as if” the election had been made on a timely basis,
- The taxpayer must have filed all required federal income tax returns consistent with the requested aggregation, and not have filed any returns inconsistent with the requested aggregation, for all of the years under scrutiny, and
- Once the election is made, all future returns must be filed using aggregation unless there is a material change in the taxpayer’s facts and circumstances which warrants the revocation of the election.
- The taxpayer timely filed each return that would have been affected by the election if it had been timely made. (For these purposes, “timely” means that the return was filed within six months of the due date, excluding extensions.)
- There is reasonable cause for the failure to meet the requirements for the election (for example, reasonable reliance on the written advice of the IRS).
The procedure contains specific requirements for requesting relief for late elections. The taxpayer must attach a specific statement to an amended return for the most recent tax year and the statement must contain a declaration explaining the reason for failing to file a timely election. In addition, the statement must include certain representations, including, among other things, that the taxpayer has filed all required and relevant returns consistent with having made the aggregation election.
Making the Election
If you haven’t made the election to treat all real estate activities as one activity, check with your tax advisor. If you’re in need of retroactive relief, he or she can help you determine if you satisfy all of the requirements and assist you in preparing the election and supporting documentation.
In a sluggish economy, you should fortify your interests. A master lease not only can help you protect your properties, but also can reduce the possibility of rent defaults.
What It Is and How It Works
A master lease covers a multitude of properties or units (spaces), with a single tenant assuming the role of master tenant and guaranteeing the rent for all the units or properties covered under the master lease.
A master lease arrangement with a credit-worthy master tenant helps to protect the owner against rental market hazards such as vacancies and lease expirations, ensuring a consistent rental stream for the lease period. In addition, administering a master lease is often easier than administrating multiple leases and dealing with multiple tenants.
Why It’s a Safer Bet
A master tenant is typically chosen for his or her pristine credit which lenders like because it can offer an extra layer of protection against loan default.
Lenders sometimes require a master lease as additional loan collateral. Master leases are especially common during the rent-up phase of a large commercial property or when an owner lacks sufficient collateral or operating track record to otherwise qualify for debt financing. If an owner defaults on a loan, the lender looks to the master tenant as a secondary source of cash flow after it’s foreclosed on the property. That is, if the lender takes title to the property, the lender can collect rent payments due under the master lease.
Adding Up the Pluses
Why would anyone cast themselves as a master tenant, considering the responsibilities of the role? It’s simple: profit. The master tenant sublets the units or properties under the master lease and becomes a sub-landlord and property manager. He or she collects rent from subtenants and, after paying the master rent to the owner, retains any funds.
The “Master” of Leases
As a property owner, you must protect your interests and properties from whatever life — or the real estate market — throws at you. A master lease can help you not only decrease the risk of individual tenant defaults, but also build a steady rental stream.
As the economy continues to wobble along, many property owners are looking for creative alternative sources of revenue. Specialty leasing programs can provide a welcome revenue boost.But it’s important to know what taking this route involves.
Should I Use Specialty Leasing to Increase Ancillary Revenue?
As the economy continues to wobble along, many property owners are looking for creative alternative sources of revenue. Specialty leasing programs can provide a welcome revenue boost.But you need to know what you’ll be getting into if you decide to take this route.
What is Specialty Leasing?
Specialty leasing encompasses a variety of arrangements for leasing nontraditional retail space. Lessees rent space for transportable “outlets” such as pushcarts and kiosks that sell smaller items requiring little or no preparation (think: cell phone accessories, jewelry or food).
The arrangements typically include leases for both short and long terms. Some retailers — such as weekly farmers’ markets or toy store outlets — may only sign seasonal leases.
Who Are Potential Tenants?
As the concept of specialty leasing has gained popularity, nationally known retailers such as Sony, Apple, Tupperware and Avon are leasing carts and kiosks to sell their products. And they’re not locating only in shopping centers — retailers and consumer product manufacturers who want to shorten their supply chains are also placing vending facilities in office buildings, grocery stores and other locations.
What Programs Work Well?
The goal is to find tenants whose products will complement your existing inline tenants’ offerings. With that in mind, you might offer retail merchandising unit (RMU) leasing in which you lease both space and an RMU (or push cart) to a business, retaining ownership of the RMU to ensure consistent design throughout your building.
Kiosk leasing allows you to lease space to a business for a kiosk it owns. And if you choose vending, you’ll lease space for cash-operated units that dispense a business’s products.
What Lease Issues Should I Be Aware of?
Before you enter into a specialty leasing arrangement, make sure it won’t conflict with any existing leases. Some leases may prohibit the use of common areas for retail purposes. Future leases for traditional space should be negotiated accordingly. Tenants might request that you agree not to locate a specialty retail outlet within a particular zone (for example, within 100 feet of their storefronts) or not to locate competing specialty outlets nearby.
Also run credit checks before agreeing to specialty lease terms. This is especially important for smaller lessees with unproven track records.
Explore the Possibilities
Specialty leasing offers opportunities for shopping malls as well as for other types of commercial properties. Your financial advisor can crunch the numbers and help you determine the most lucrative specialty arrangements for your property.
Vault.com Ranks Marks Paneth Among Nation’s Top 20 Accounting Firms
Marks Paneth ranked number 19 in the Vault Accounting 50 for 2012, Vault.com’s annual survey of the top 75 accounting firms in the US based on their Accounting Today rankings. This rating reflects both the market’s recognition of the firm’s increased prestige within the industry and staff satisfaction. The survey measures overall industry prestige and quality of life variables for employees.
Increasing Business Cash Flow with an ESOP
In the current economic environment, business owners are searching for strategies to increase their available cash flow. In his article, co-authored with Robert B. Danziger, Esq and Jay Fenster, Esq., Marks Paneth Partner Ron Nash notes that this becomes critical when the business owner, struggling to find capital to expand his business, must then find the resources to pay taxes on his business income. This perpetual burden on cash flow can be reduced, almost to zero, with proper planning. (Please see the full article in the Library)
Marks Paneth Joins Morison International
Marks Paneth is committed to providing our clients with high-quality professional services, no matter where their business takes them. This is facilitated by our membership in Morison International (MI). MI is a global association of leading independent accounting and consulting firms. It serves clients with complex needs across multiple jurisdictions and continents. MI provides high-quality, full-service member firms worldwide with the ability to meet the cross-border needs of the most complex business models.
Our membership in MI affords us the opportunity to collaborate with other outstanding professional services firms around the world.
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Marks Paneth is committed to providing our clients with high-quality professional services, no matter where their business takes them. This is facilitated by our membership in Morison International (MI). MI is a global association of leading independent accounting and consulting firms. It serves clients with complex needs across multiple jurisdictions and continents. MI provides high-quality, full-service member firms worldwide with the ability to meet the cross-border needs of the most complex business models. Our membership in MI affords us the opportunity to collaborate with other outstanding professional services firms around the world.
Treasury Regulations require us to inform you that any Federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
© Marks Paneth LLP 2012
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About Harry Moehringer
Harry Moehringer, CPA, brings more than 35 years of public accounting experience to his position as the Managing Partner of Marks Paneth LLP. In this capacity, he oversees the firm's operations, manages business development efforts and consults on key clients. He is chairman of the firm’s Executive Committee and plays a major role in developing strategy, setting policy and overseeing acquisitions. Prior to becoming Managing Partner in 2012, Mr. Moehringer served as the Partner-in-Charge of... READ MORE +