Money Talk

Episode 55

Transitioning the Family Assets


Welcome to our listener-supported podcast, Money Talk, unpromised absolute financial truths behind financial perceptions with hosts Ed Sutkowski and Chuck LeFebvre. Let’s listen in. 

Chuck: Welcome to Money Talk. I’m Chuck.

Ed: I’m Ed.

Chuck: Ed, today we’re talking about–

Ed: Transitioning the family assets. That could be just assets, or it could be a business, stocks, bonds, whatever. The point is, how do you move assets from one generation to the other, especially if we have a family with, say, four siblings. Two are involved in the business, one is involved in the business, married, several children. How do you approach first the form of the organization?

Chuck: Good question.

Ed: What’s your view there, Chuck?

Chuck: Well, I guess, first of all, a lot of times there’s very little flexibility by the time someone is to the age where they are contemplating that passing along at their death. Specifically, if what they have is a corporation, either a regular corporation or an S Corp, and if there are assets embedded in that corporation that have appreciated in value. Then there are some tricks that can make it a little bit difficult to change the nature of that organization prior to their death.

Ed: Stepping back, the lesson is you should, you meaning husband, wife, family members think about the ultimate destination of the asset and early on in the asset accumulation process.

Chuck: Yes.

Ed: Planning at the outset is critical.

Chuck: Right, and we run into a lot of situations where farmland in particular, or other real estate is embedded in a corporation. I don’t think that’s because people failed to plan, it was because when they created those corporations, the laws were a bit different than they are now, or the trade-offs were a little different and so it made sense then, and it no longer does and it’s kind of hard to unwind it.

Ed: Yes. The lawyers dream fair, greed, government, and revenge. Sibling rivalry tends to be right up on the scale of gross receipts. The more the sibling rivalry occurs, the greater the cost of the transaction. Let’s assume, worst case, you have a corporation been along for around for a long time, it owns real estate. Let’s assume it’s farms for just a moment and we have more than one child.

Chuck: Low basis, we’re assuming low basis compared to the-

Ed: Yes. By that I mean when the corporation was formed, it was formed for, say, $10,000 in cash, 40 years ago, and it accumulated all kinds of other assets. Let’s assume it’s farms, make it easy, that are not really divisible. One farm is worth more than the other.

Chuck: Right. 

 Ed: Let’s assume we have four children

Chuck: Right. 

 Ed: And let’s assume they’re all boys.

Chuck: This is pretty easy to imagine. We come across this all the time, right?

Ed: Yes. Let’s assume that they’re not all involved in the business, which, by the way, is the norm.

Chuck: Right. You’ve got one or maybe two.

Ed: Yes, and we’re talking about not the child generation, but our grandchildren, and our great grandchildren. I want to keep the farms forever. I want to keep the apartment buildings forever, keep the stocks forever. Well, wait a minute, nothing lasts forever but let’s see how we can accomplish your objectives with the least possible shrinkage in the form of taxes, in the form of fees, costs, and expenses and how can we preserve the family intact? Have you ever had that problem?

Chuck: Yes. That’s what I would call the normal estate plan.

Ed: That’s right.

Chuck: This is kind of what we deal with all the time. And of course, I’m not sure that we’ve run across a one size fits all solution to that problem.

Ed: I must tell you Chuck, you don’t know how right you are. Everyone is different and they say “Oh, that’s the same.” No, the only thing that is constant is the differences.

Chuck:  Right. Let’s say this is a family where you can devise the easy solution, which is the easy solution. Which is to simply say, well, we’re going to just give this farm, this corporation to all four of the children equally, and the one who’s currently involved is just going to continue to manage it and everybody’s going to be happy forever.

Ed: Yes, right.

Chuck: Of course, the problem with that is that even if that turns out to be true for the generation that immediately succeeds the person for whom we’re doing this planning. You still have to worry, like you said before, about subsequent generations or divorces that occur among some of those folks. Who then suddenly you’ve got not one of the children who owns a piece of the farm, but one of the children’s former spouses who owns a piece of the farm.

Ed: Yes, and we see they asked the Pritzker family about hotel organization. Now let’s assume the base case, four siblings, five farms and all have appreciated in value. One solution. It’s a regular corporation in the sense that it’s an Illinois corporation, Florida, Wyoming, whatever that is just being taxed at its own rate of 21% in the first x thousand. Anyway. Now, how do we handle that? Well, one way of handling it is to split it up. In other words, this corporation, we’ll call it OldCo. OldCo forms four corporations or three that is. So, each child will end up with one corporation and it will own either a farm or a fractional interest in the farm. And that is tax-free under certain circumstances. When the day is done there are now four kids, four corporations. They can elect to be taxed as an S corporation. They can do whatever they want. Who’s going to manage the farms? That’s an easy solution at a cost of x thousands of dollars to get it done tax-free.

Chuck: Right. 

 Ed: But if you were planning-

Chuck: It’s not even all that guaranteed that you’re going to be able to split that up tax-free.

Ed: It’s not a guarantee but if they’re really at each other’s throats.

Chuck: Then you can.

Ed: Then you can. It’s funny that the greater the anger the less the tax.

Chuck: Right, but what if you’re trying to prevent that. They’re not at each other’s throats yet, and then you’ve got mom and dad are trying to vise this plan.  And they know if I leave this to the kids, they’re going to be at each other’s throats. Councilor, how do I handle this?

Ed: The easy solution is the regular corporation. You elect to be taxed under additional subchapter S, which means corporation essentially pays no tax except on some of the appreciation, unless they held that S-election for five years. Bottom line is you elect subchapter S, and so then you enter into a buy sell agreement that provides for the one individual that’s managing the company. The president gets base compensation with some perks. Then you require annual distributions of the excess cash, but in no event less than the amount of the tax that will be payable by each of the shareholders.

Chuck: With you so far.

Ed: Then things can go on for generations. You can have a limit of 100 shareholders of a corporation, but that’s per family.

Chuck: Right. 

 Ed: You’ve got all kinds of opportunities. We know at least one bank that has I don’t know how many shareholders, but they’re all related somehow. They’re all Polish.

Chuck: In this situation, and typically, when you have an S Corp, there’s also a shareholder agreement, which helps keep everyone in line.

Ed: Yes, and you provide that, you can only transfer within the family, and you could have a put. Shareholder can be allowed to put the shares back to the company. Company would buy it back. Now, over a period of time, depending upon the liabilities and assets at that time, you take into account the value of the underlying asset, net of the tax that would be paid. It’s kind of a lawyer’s dream, but it’s not that complicated.

Chuck: Right. 

 Ed: When you think about it, because the non-active shareholders are getting cash. 

Chuck: Right. 

 Ed: You get cash is returned so next topic.

Chuck: Right. 

 Ed: So you don’t have to go through this what’s referred to as a 355 reorganizing. That’s a bit of a lawyer’s dream, but it could be tax-free, but still doesn’t solve the problem.

Chuck: Right. 

 Ed:  The S election seems to solve the problem. But let’s assume that we’re clairvoyant. We have this family coming in. Mother, father, and they have these four children, they’re all very young. You have an option to set it up. How would you set it up? What organization would you suggest, Chuck?

Chuck: In that situation assuming we crossed the threshold or we’ve decided we want to create a business entity to hold this farm ground, I would be recommending an LLC rather than a corporation, because there you don’t have the issue with the appreciated real estate being sort of being locked inside the organization and unable to be distributed out without incurring capital gains tax, which is what happens with the corporation.

Ed: I’m not sure I understand. A farm that you paid 3000-acre Fort South, 13,000. 

Chuck: Right. 

 Ed: And $10,000 in gain. If it were to be sold, there’d be a tax at the corporate level.

Chuck: Right. 

 Ed: Assuming we have a regular corporation. 

Chuck: Right. 

 Ed: If it had been S and held for more than five years, there’d still be, in some cases a state tax, but nonetheless there’s a tax.

Chuck: Right. 

 Ed:  Versus in the limited liability company, you could send that farm out to one individual with no tax.

Chuck: Correct. Yes. Assets generally in an LLC can move in and out of the company without there being tax at either the company level or the shareholder level unless there’s an actual sale of the asset. It makes it a little bit easier to split things up, divide things out, get rid of somebody who just wants out of the company. If there’s no cash, you can give them property. They can take their share of the property and walk away. There’s generally quite a bit more flexibility there.

Ed: When we talk about a limited liability company, that means there is a limited liability second corporation from third-party creditors,

Chuck: Right. With the LLC, let’s say it’s owned by mom, dad, or one of them, and they die, you get the basis step-up on the LLC itself if they’re the ones holding-

Ed: Wait a minute, I don’t understand that tax basis step-up.

Chuck: That just means that, the new cost basis, let’s say the farm was bought for $3,000 an acre, that’s the cost basis. If that’s the only capital that was contributed to the LLC when it was created, the cost basis for the LLC is $3,000 an acre times however many acres you put in there. But mom and dad die, you look at the fair market value of the LLC on their date of death. That becomes their basis in the LLC meaning-

Ed: Interest, like shares.

Chuck: Yes. With the LLC, you can make what’s called a 754 election where effectively this new basis that is created on their interest in the LLC itself also applies to their basis in the farm that’s held inside the LLC.

Ed: Let me get that straight. You got 100 acres. You got a gain of $10,000 an acre. You die. Mother and father both die. You can elect this sister section that you talked about, and therefore that new value of the farms gets increased inside the organization.

Chuck: Inside the organization to the extent of mom and dad’s ownership of the organization. If they own all of it, let’s make this simple by saying they die together. This all happens at once then suddenly that asset inside the organization can be sold without capital gain.

Ed: Sounds like an accountant’s dream to me.

Chuck: It is an accountant’s dream. It’s kind of not because there’s no tax to save people since it’s already been saved. That doesn’t happen if you have a corporation. Let’s say you have the same situation.

Ed: The S corporation.

Chuck: Well, either.

Ed: You’re telling me this tax basis step-up, this, what do you call it, 754 election is not available to a shareholder of an S corporation?

Chuck: Correct, so you get a new basis on the

Ed: Shares

Chuck: shares of the corporation. That’s great. You can sell your shares of the corporation now for fair market value after your death, and there’s no capital gain on that. The farm inside that corporation, if that’s sold, there’s still capital gain.

Ed: Now wait a minute, I want to buy the shares, buy 25% of these shares at the fair market value of the land. Wait a minute, that’s not true because that fair market value inside the corporation has got to be adjusted for that gain.

Chuck: Exactly, the shares are actually worth a little bit less than the farm that’s embedded inside that because of the built-in tax liability.

Ed: That’d be about 23.8%, something like that.

Chuck: If you look at, assuming you’re in a category where the so-called Obamacare tax applies, which is 3.8% plus the 20% capital gain rate, 23.8%, that’s the federal level depending on what state you’re in, there could be state taxes in addition to that. That’s what we mean when we talk about assets being trapped inside a corporation. There’s no way to get them out. There’s no way to sell them without there being some recognition of capital gain tax.

Ed: Now, I get all that about the numbers and that’s fine, but I’d like to focus on the dispute resolution. Or putting it another way, avoiding a dispute. With the LLC, then I can do some designing.

Chuck: Correct. The less you’re boxed in because of tax rules, the easier it is to do whatever is necessary to avoid disputes without regard to how the transactions you’re trying to organize are going to create tax liabilities.

Ed: For example, I can create three classes of shares or membership interests bearing different rates of return. I can have an employment agreement. I can have a required distributions. I can put in tax qualified. I could do all sorts of fancy stuff.

Chuck: Oh, yes. I’ve done any number of LLC operating agreements, which is like for an LLC, the equivalent of corporate bylaws where the operating agreement itself says X is the manager. We’re appointing Mary to be the manager. Mary is able to appoint her own successor if the owners of the organization decide that she can’t manage the organization anymore. That is basically impossible to do with a corporation. With a limited liability company, you can put provisions in an operating agreement that look an awful lot like a trust or an estate plan.

Ed: You can also think, and we’re not limited to a limited liability company. We could have just a regular partnership. 

Chuck: Yes. 

 Ed: Although there’s some creditor issues there. We have a limited liability partnership, limited liability. We do all different businesses have combinations

Chuck: Right. 

 Ed:  But the point is pre-planning,

Chuck: Right. So, in my mind, there’s LLCs, limited liability partnerships, limited liability limited partnerships, and then this thing called limited partnerships. Those all are sort of different versions of a species that I think we can generally talk about that as an LLC. The difference is between, those really have to do with the way the relationship between the owners and the managers of that company versus third-party creditors. But, in terms of family planning, they all give you the same level of flexibility. Do you agree with that or am I missing something?

Ed: No, I agree. The upfront design is what colors the whole transaction. Often times you get something coming in the office that’s been set up years and years ago. How do you satisfy concerns? The big concern without any doubt is where’s the money, honey?

Chuck: Right. 

 Ed: When you have one or more of the siblings or descendants active in the organization, the issue is what is fair compensation for those services rendered? That’s easily solved by reference to third-party independent marketplace issues. Then how do you get the cash out to the inactive owners?

Chuck: Right. 

 Ed: Whether it’s children, grandchildren, or great-grandchildren. How do you keep it within the family group? Let’s assume it’s a great business organization that sells widgets and the cash returns are significant. As long as everyone’s getting cash let Charlie run it or Mary run it, that’s fine, fair compensation. But, as soon as there’s a disproportionate compensation, either too much or not enough, and enough money coming out to the descendants, guess who wins?

Chuck: The lawyers.

Ed: The lawyers.

Chuck: Yes. This is actually one of those areas where the rigidity of the corporate structure can kind of provide a benefit. Because, for instance, if you have an S Corp in particular, then there’s no gamesmanship allowed in terms of how those profits are distributed out of there. If you’re a shareholder, it doesn’t matter if you can have voting and non-voting shares, but there’s no different classes of stock. A is getting bigger dividends than B. Everybody’s getting the same profit distributions. Generally, there’s always going to be a shareholder agreement that says that at least as much as is necessary to cover the tax liability is being distributed out annually to everybody. That in itself can be a little bit of a peacekeeping feature, I guess.

Ed: The message that I’ve been given by groups of clients is, how do we preserve the relationship among the siblings? Things are fine when mom and dad are around, but if they’re ghosts, things change.

Chuck: I had one client who said, “Chuck. Go ask my kids.” Find out how they’d like to get their inheritance from them.

Ed: It isn’t so much the kids, it’s the in-laws. Pete said, “Look, I can do much better in cryptocurrency than let’s get the cash and run and boom, and it’s all gone.” In other words, there’s so much psychology in this issue that I’m confident that law schools missed the boat and failing to focus on the psychological aspects of planning.

Chuck: It’s not discussed at all, as far as I know.

Ed: No, I couldn’t agree with you more. You go out in the world, all of a sudden client one comes in and he’s talking about the situations that, wait a minute, that’s not in my textbook. 

Chuck: Right. 

 Ed: It’s the division of authority, division of financial issues, distributions, but cash is king, queen and the whole deck of cards.

Chuck: That’s true. Not just in the context of family conflict, but any kind of business discussion.

Ed: Yes. If I’m getting the cash, everything’s fine. 

Chuck: Yea. 

 Ed: We get to the issue of how do you fairly compensate the individual who’s running it? We’ve had a series of podcasts on these tax-qualified arrangements. SEP/IRA, the individual is older, cash balance pension plan, which as far as I am concerned, again, is the greatest thing since sliced bread.

Chuck: It is.

Ed: The actuaries can do all the legal work, I call it, that can be delegated off. Yet, if there’s enough money in an IRA, things change.

Chuck: Oh, yes very much so.

Ed: I think we’ve addressed some of the assets that nationwide there’s 314 individuals owning IRAs with more than $25 million in them.

Chuck: That is pretty amazing. That is a small audience for our podcast, Ed. We’re trying to get more, right?

Ed: Yes.

Chuck: Encouraging people to do these cash balance plans. They can have their IRAs grow. That’s really the best way to get a big IRA.

Ed: You put the money away under a cash balance pension plan, and at age 62, you transfer it to an IRA. Money solves issues.

Chuck: It does, yes.

Ed: It permits these people, these owners, to pursue their passion. Putting it another way, what would you do if you weren’t earning anything versus what would you do if you had to pay to do what you are doing?

Chuck: That’s an interesting question. If you had to choose a career that you had to pay–

Ed: To do it.

Chuck: It’s an easy question for us to answer, since lawyers have to pay to go to law school.

Ed: That’s right.

Chuck: We know what our answer is.

Ed: It’s a great experience. Then they add three years with a Socratic approach, anyway, yes.

Chuck: That’s a good thing for people to wrap their minds around when they’re really trying to figure out how to pursue their passion.

Ed: How much per hour are you willing to pay to be able to do sliced bread?

Chuck: Probably not a whole lot.

Ed: To do what we do, I think I might pay some money. To do what– I take that back.

Chuck: Some of it, though.

Ed: Some of it, yes, because so much of it is a learning process, because each engagement is different.

Chuck: Right. It’s interesting and it’s a fascinating career.

Ed: What would you do if you weren’t practicing law, Chuck?

Chuck: Oh, I don’t know, probably something more creative, probably something in the creative. I don’t know if I’d be any good at it, but–

Ed: What would that be?

Chuck: I’d try something, some type of writing or artwork.

Ed: What about your background is math. Would you pursue that?

Chuck: Some of those things are math. Musical is kind of mathematical.

Ed: It’s all mathematical.

Chuck: I think I would do– the kind of writing I have in mind might be technical writing, so it would be something along those lines.

Ed: I don’t know if they asked me–

Chuck: You know the other thing all those have in common is the absence of a boss.

Ed: That’s right. I don’t want anyone tell me what to do. I want to be able to do what I want to do when I want to do it, if at all. That’s one of the benefits of practicing law, as we do. 

Chuck: Right. 

 Ed: Now, if you’re with a big organization, great, I’m with X, Y, and Z. I’m impressed, I’m impressing people at a cocktail party. Are you having fun? No. You have to have fun. I was thinking what I would do, and I don’t want to even go there. I’m having too much fun now. Rather than pursue the psychology of us, the point is, cash is king.

Business organizations are great vehicles to accumulate and pass wealth and just make sure you don’t give the descendants too much too soon, because you’re going to deprive them of the opportunity to enjoy the process.

Chuck: Agreed.

Ed: Thank you. Next topic.

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