The IRS has at last issued long-anticipated proposed regulations under Code §2704.  We perceive the proposed regulations as an attempt by the IRS to curtail the use of discounts – such as minority interest and lack of marketability discounts – in valuing transfers of interests in family-controlled entities for gift and estate tax purposes.

“Family limited partnerships” – that is, family investment entities usually structured as LLCs or limited partnerships – have been a popular estate planning technique for years.  Generally speaking, a client can transfer non-voting, non-marketable interests in these types of entities to children or a trust, and claim a valuation discount due to the restrictions that apply to the interest transferred.

Code §2704 provides that certain “applicable restrictions” on ownership interests in family entities, ie, entities where the transferor and family members control the entity, should be disregarded for valuation purposes.  The statute also permits the IRS to issue regulations providing for other restrictions (as determined by the IRS) to be disregarded in determining the value of a transfer to a family member, if a restriction has the effect of reducing the value of the transferred interest but does not ultimately reduce the value of such interest to the transferee.

The proposed regulations make two overarching changes.  First, changes under Code §2704(a) create new rules relating to a lapse of a liquidating right.  These changes are less relevant, at least in our practice, as we generally do not structure entities to include liquidation or other rights that lapse.

Second, changes under Code §2704(b) create a new concept of “Disregarded Restrictions.”  Under the proposed regulations, a restriction that will lapse at any time after the transfer, or a restriction that may be removed or overridden by the transferor (or the transferor and family members acting together) will be disregarded for gift and estate tax valuation purposes.  This is the case even if the restriction on the interest is pursuant to state law rather than a governing business agreement.  There are certain exceptions – for example, an owner’s right to liquidate or “put” his or her interest to the entity and receive cash within six months is not considered a “disregarded restriction.”

The effect of this rule appears to be that it would eliminate minority interest discounts, because the holder of any interest would be deemed to be able to liquidate his or her interest in the entity without restrictions.  The effect of the proposed regulations on lack of marketability discounts is unclear, although it seems the IRS similarly could argue for a small or zero lack of marketability discount on the theory that the holder of the interest is deemed to be able to liquidate the interest.

Thus, if the proposed regulations are adopted in their current form, they likely will increase the value for gift and estate tax purposes of transfers of interests in family-controlled entities.

The proposed regulations are controversial.  Commentators already have questioned whether the Treasury has exceeded its statutory authority in issuing the proposed regulations.  The proposed regulations are (at least in this author’s opinion) complicated and ambiguous, and perhaps unfair.  For example, if a client creates an LLC to purchase and manage a commercial property, and the client transfers an interest in the LLC to his or her child, and the interest is subject to typical restrictions on sale of the interest or the ability of a member to liquidate (largely because the asset owned by the LLC is illiquid and perhaps leveraged), then it seems that the true value of the interest transferred to the child would be reduced due to these restrictions (think about what a willing buyer would really pay the child for the LLC interest); however, under the proposed regulations, the value of the LLC interest transferred would be artificially inflated for gift tax purposes.

The proposed regulations are not effective until they are finalized.  Treasury has requested written comments by November 2, 2016 and a public hearing on the regulations is scheduled for December 1, 2016.

We are seeing an uptick in audit activity by state tax authorities of closely held businesses, particularly in the area of sales and use tax, to generate much needed revenue for meeting budget shortfalls and funding services and entitlement programs.  A go-to audit technique is to examine whether a company has “nexus” with its state.

The question of whether your company has “nexus” with other states can lurk in the background of its normal multi-state activities, until all of a sudden it explodes in an audit.  A company that has failed to file returns and pay tax where there is nexus may face an audit for the past six to eight years generating substantial tax liability.  In the case of a trust fund tax (such as sales tax) there is also personal liability to a company’s owners and officers that is not a dischargeable debt in bankruptcy.

Definition of Nexus

An out-of-state (“foreign” or “nonresident”) business with significant physical presence in another state will have nexus with this other state.  The reason is that such business will be considered to avail itself of the state’s benefits and privileges (this assumption is automatic for resident businesses) and, in turn, the state will have jurisdiction to impose “privilege” taxes, of whatever specific kind, on the nonresident business.

Physical contacts in the state, beyond outright ownership or leasing of property, may include in-state deliveries (other than by common carrier) and banking activities in the state.  For sales tax purposes, such contacts also include solicitation of sales, whether by employees, independent contractors or other agents.  In addition, states have become increasingly aggressive and have asserted “economic nexus” based on non-physical contacts with the state, such as “click-through” nexus / internet referrals, licensing a trademark, and banking and financial services.

The two most common types of tax imposed by states on out-of-state businesses through nexus are income tax and the obligation to collect sales and use tax from customers.

Income Tax

State income tax is generally imposed on a nonresident business on income sourced within the state.  However, income derived from solicitation activities is protected by federal statute, 15 USC § 381 (commonly known by its 1959 enacting legislation, “P.L. 86-272”).  Under P.L. 86-272, a state cannot impose corporate tax on a foreign business, even when there is nexus, if the tax is based on, or measured by, the business’ gross or net income if: (1) all such income is derived from solicitation of sales of tangible personal property, and (2) orders are approved and shipped from out of state.

Note that P.L. 86-272 does not protect: (a) income derived from solicitations of sales of services, real estate or intangibles, and (b) non-income franchise tax calculated based on gross receipts, apportioned capital, net worth and other non-income measures.  For example, Washington State is notorious for targeting out-of-state companies with tenuous business activities in the state for failure to pay its Business and Occupancy Tax.  Other types of such non-income taxes that have been known to reach companies “doing business” out of state include Michigan Business Tax, Texas Margin Tax, and Ohio Commercial Activities Tax.

Sales and Use Tax

P.L.86-272 only protects solicitation activities from income tax.  For sales tax purposes, solicitation of sales by subsidiaries, agents or affiliates, who are residents of a state, on behalf of a foreign business will create nexus.

In fact, many states have made nexus automatic (and also not purely based on physical nexus), through a rebuttable presumption that a foreign company’s in-state referral sources are soliciting sales, by internet or otherwise, to generate their commissions.  The burden of proof shifts to a company having to prove the opposite: that a referral arrangement with a resident does not cause such resident to solicit sales, by internet or otherwise, generating a sales tax collection obligation.  New York’s highest court has upheld this type of statutory presumption (referred to variously as “click-through nexus,” “commission-agreement provision” or “Amazon law”) against constitutional challenge by online retailers Amazon.com and Overstock.com.

Nexus Study / Diagnostic Check

In light of the potential tax pitfalls facing a business with regular ties to various states—direct or indirect, physical or economic—every multi-state business should periodically perform a state-by-state diagnostic check, or nexus study, of its activities, such as:

  • Ownership or leasing of real property (store, warehouse, office) or personal property (machinery or equipment).
  • Inventory maintained in a warehouse or by sales representatives.
  • In-state deliveries to customers in company-owned vehicles.
  • Local media advertising (e.g., phone directory or telemarketing service).
  • Employees attending trade shows, or conducting training or seminars.
  • Active solicitation of orders for sales (for sales and use tax purposes).
  • Solicitation activities beyond the protection of P.L.86-272, such as solicitation of sale of services, real estate or intangibles (for income tax purposes).
  • Installation, repair, or maintenance services.
  • In-state order approval, receipt of payment, merchandise returns and customer complaint resolution.
  • Affiliate referral programs, internet-based or otherwise.
  • License, royalty or other fee arrangements.

Once a company completes a nexus study questionnaire, and personnel interviews, regarding its specific activities in various states, this information is analyzed in light of current law by state and area of tax.  A confidential attorney-client privileged memo summarizing the nexus study results is then provided to the business.  The company can then make informed decisions with its tax counsel on how to minimize its multi-state tax exposure.  The business may choose to alter its business practices to eliminate nexus in one or more states.  If that is not possible, it may choose to make voluntary disclosures through available state programs to potentially obtain a limited look back period and waiver of penalties.

Conclusion

In the wake of dramatic budget shortfalls and deficits, states are eager to wage nexus audits on out-of-state businesses, generating significant payments of income tax, sales and use tax, interest and penalties.  If your company operates in a multi-state market, is not registered to do business in other states and is not paying income tax or collecting sales tax, it is critical that you engage a tax attorney—that has the benefit of a confidential-attorney client relationship—to conduct a state-by-state nexus study.  Failing to do so may cause your company to be blindsided by what could be substantial (in some cases multimillion dollar) tax liability that may also be a personal debt for its owners and officers.

Prince was not the first famous person to die without a Will.  Others who died intestate include:  Abraham Lincoln, Ulysses S. Grant, Howard Hughes, Martin Luther King, Jr., Sonny Bono and Pablo Picasso.  Dying intestate is usually a huge financial mistake.

In Prince’s case, as in similar cases of intestacy, dying without a Will causes several problems.  First, there is confusion among the family as no one knows what his true wishes were.  Confusion often leads to litigation.  Second, the costs are often greater because the steps to administer the estate are more involved.  For example, an administrator usually needs to pay for and post a bond (based on the value of the estate), whereas an executor named under a Will generally does not.  Third, Prince’s assets will pass under the rules of “intestacy” (in this case the law of Minnesota), which often is not the distribution (to family or charity) that the decedent would have wanted.  This can be especially problematic for single people or those in second marriage situations.  Fourth, if minor children are involved, a court proceeding will be necessary to name guardians for them.  And, without a Will, the decedent makes no provision for taxes and expenses, which can result in large tax liabilities or other unintended consequences.

All of these outcomes are easily avoidable.  In Prince’s case, the estate appears to consist largely of real estate and intellectual property rights (ie, his catalog of published and unpublished music).  From the tax planner’s perspective, this means it is largely illiquid, which is problematic.  The federal estate tax, imposed at a rate of 40%, is due nine months from the date of death.  Although it may take months to determine whether Prince actually had an estate plan, at the moment it appears the artist took few, if any, steps to plan for liquidity to pay taxes or to reduce his estate tax exposure.

Outdated Wills also present problems.  Fiduciary choices (executor, guardian, trustee) often change over time.  In addition, our choices as to who should inherit our property also may change over time.  We all know a story about someone who unexpectedly (or undeservedly) inherited under a Will, or someone who was unintentionally left out.

In a notable case in our office, we represented the estate of a deceased estate planning attorney who did not update his own Will for over 40 years.  The document led to significant litigation due to outdated tax planning and unanticipated tax allocations, among other problems.

Most of us, therefore, should have up-to-date Wills.  The Will governs the disposition of your assets and ensures that these assets pass to your family and loved ones in the manner you desire.  A Will usually includes tax planning, that is, setting up a structure that minimizes federal and state estate taxes.  You appoint an executor, the person who is responsible for carrying out your wishes.  You may also appoint guardians for minor children, and trustees for any trusts created under the Will.

Basic estate planning documents also include a power of attorney and health care directive – documents to plan for incapacity by naming an agent to make decisions on your behalf if you are unable.  Estate planning documents should be reviewed by an attorney every three to five years or following a significant life event.

Proper estate planning is a gift to your family.  It accomplishes your objectives, avoids confusion, saves money, minimizes taxes, and gives you the peace of mind of knowing that your affairs are in order.

It is difficult enough for families to come to grips with having to care for an elderly parent that may no longer be able to live on their own.  After coming to terms with this unfortunate reality, the next steps often involve moving that parent into their home, an assisted living facility or a nursing home nearby.  With all of this turmoil, it should be no surprise that most people would not consider whether such a move may create a significant estate tax liability should that parent die, even if it is shortly after such a move.  Your parent could live their entire post-retirement life in a state such as Florida where there is no estate tax and when they are no longer able to live on their own, you bring them to your home state.  If you pack your parent up, sell his or her home and get them established in new living quarters in New Jersey, should they die even a few months later, their entire estate could be subject to an expensive New Jersey estate tax.  How could this be?  Because New Jersey will take the position that your parent had either voluntarily changed his or her domicile, or if incompetent to do so, he or she has taken the domicile of their guardian.  What does this mean?

A change of domicile occurs when there is both a physical presence in the new locality (with an intention to permanently relocate) and an intention to abandon the old domicile.  In other words, once you permanently move to a new home and abandon your old home, you avail yourself to your new home’s tax laws. What about the adult who lacks (or who may soon lack) the capacity to change his / her domicile voluntarily and by his or her own act?   In New Jersey, domicile may be acquired in one of three ways: (1) through birth or place of origin; (2) through choice by a person capable of choosing a domicile; and (3) through operation of law in the case of a person who lacks capacity to acquire a new domicile by choice.  Importantly, even after an adjudication of mental incompetence, a person may nevertheless possess sufficient mental capacity to elect a new domicile, and it is generally recognized that his or her actual capacity to do so is a question of fact.  However, once incompetency has been shown, there is a presumption that the incompetent lacks the mental capacity to make such a choice and the burden of showing that he or she in fact possessed the necessary mentality shifts to the party claiming that his domicile had been changed.  How does the NJ Division of Taxation view it?

The 1969 Appellate Division case Estate of Gillmore is the authority for the above and very much remains good law today.  In Gillmore, the executors of the decedent’s estate appealed from an assessment of the New Jersey Inheritance Tax Bureau against the estate. Two years before Gillmore’s death, having become hopelessly senile, the decedent was moved from her New York apartment by her brother, who was named her guardian, into his New Jersey home for several weeks, and thereafter placed in a New Jersey nursing home. The executors claimed that the decedent had never been a New Jersey domiciliary, a prerequisite to assess tax.  The Court affirmed a judgment for the Tax Bureau on the grounds that the decedent, though incapable of acquiring a domicile other than New York by choice, acquired one in New Jersey by operation of law through the guardian.  This decision is reinforced by New Jersey law that provides that a guardian of the person has the authority to “establish the incapacitated person’s place of abode within or without this state.” N.J.S.A. 3B:12-57(a).  The New Jersey Division of Taxation continues to take the position that if your parent dies in New Jersey after having moved here, even if only for a short period of time, in most instances, they are expecting a check based on the value of their entire estate.

New York Courts have taken the opposite position in holding that an adjudication of incompetency and the appointment of a guardian for the incompetent is as a matter of law conclusive as to the incompetent’s legal incapacity to change domicile by his or her own act until he or she has been judicially recognized as competent or has been restored to sanity by a court of competent jurisdiction. This rule is apparently based on the following considerations: (1) that a person adjudged incompetent by a court is presumed to be incapable of choosing a new domicile; and (2) that only the court, which adjudged him or her incompetent retains control and only that court can determine a whether the incompetent’s domicile changed. This holding was originally set forth in the case In re Meyer’s Estate, 59 Misc. 2d 507, 299 N.Y.S.2d 731, 734 (Sur. Ct. 1969), which has also continues to be cited in current cases and remains good law today.

Believe it or not, New York is now a much more friendly estate tax home than New Jersey.  New York has no inheritance tax and its estate tax exemption is scheduled to be in line with the federal exemption in 2019.  New York’s currently exempts $4,187,500 where New Jersey exempts only $675,000.  Although there is pending legislation that may raise New Jersey’s estate tax exemption, it is unclear if that law will pass.

There is no suggestion by the authors to turn away an elderly parent in need of new living quarters in favor of potential New Jersey estate tax savings.  However, there are many steps that you can take as their advocate to avoid a New Jersey estate tax trap for your elderly parent who may be living in a no estate tax jurisdiction such as Florida.  If your parent lacks (or who may soon lack) capacity, but has lucid moments and is not completely incapacitated, you may be able to take effective steps to preserve their old domicile and avoid an unnecessary New Jersey estate tax upon their death.  These steps may include: (i) not establishing a new domicile in New Jersey; or (ii) not abandoning your parents’ former domicile in Florida.  There are several specific steps that you and your elderly parent can do to bolster the positon that they are not subject to New Jersey estate tax notwithstanding that they may have been living in New Jersey before he or she passed.  Managing your elderly parents’ affairs is never easy.  Adult children who care for their parents, however, must be mindful of this potential tax trap. Once you get your parent set up in their new living quarters, it is imperative that you consult with an experienced state and local tax professional for tax planning advice.

Many New Yorkers who want to move to Florida still desire to retain a home, an apartment, or some other type of property in the place where they grew up.  What many of the newly minted Florida residents may not consider are the estate tax consequences of continuing to own property located in New York.  In light of the changes to New York’s estate tax laws in the past two years, we set forth some important rules that the old New Yorker / new Floridian should keep in mind.

A primer on New York estate tax law is helpful before considering the issues associated with being a Florida resident who owns property located in New York.  New York imposes an estate tax at rates ranging from 4% to 16% on its residents (and also nonresidents, as will be explained below).  However, New York law also provides that anyone owning less than $4,187,500 in assets is exempt from New York estate tax.  This exemption increases to $5,250,000 on April 1, 2017 and finally increases again on January 1, 2019 to equal the federal exemption (which is currently $5,450,000 as adjusted for inflation).

Therefore, if an individual’s total estate is less than the New York exemption amount, that individual need not be concerned with New York estate tax.  In addition, if the total value of a Florida resident’s New York assets is under the New York exemption, that individual also need not be concerned with New York estate tax.  But, what if a Florida resident’s New York assets are valued over the New York exemption?

New York’s estate tax applies to nonresidents owning real or tangible personal property located in New York.  It does not apply to intangible property owned by Florida residents.  Tangible personal property is defined in the negative, meaning New York law sets forth assets that are considered intangible, and therefore not subject to New York estate tax, including bank deposits, shares of stock, bonds, mortgages, debts and receivables.  Tangible personal property includes assets that (i) are movable,  (ii) have physical characteristics, and (iii) are capable of being possessed – boats, cars, artwork, jewelry, antiques and other collectibles.

New York’s estate tax also applies to any gifts made within three years of an individual’s death.  For the individual who has recently moved to Florida, this means that the value of any gifts by that individual while he or she was a New York resident of real or tangible property located in New York or intangible personal property relating to an active business, trade or profession in New York will be considered for determining whether the Florida resident is subject to New York estate tax.  This three year add-back only applies to gifts made after April 1, 2014.  The rule will not apply to estates of individuals who die after January 1, 2019.

To illustrate how New York estate tax law operates, take for example a Florida resident who owns a vacation home in the Hamptons valued at $6,000,000. That individual would be subject to New York estate tax because the value of the home ($6,000,000) is greater than the current New York exemption ($4,187,500).  Also note that, unlike federal estate tax law, once an individual’s estate exceeds the New York exemption, the value of the individual’s entire estate is subject to New York estate tax, not just the amount over and above the New York exemption. Therefore, in our example, the entire $6,000,000 would be subject to New York estate tax (not just $1,812,500).

What if that same Florida resident instead owns a cooperative apartment in New York City and does not own the Hamptons home? That Florida resident would not be subject to New York estate tax because that individual owns shares in the cooperative apartment, which is considered an intangible asset.

Now assume that the Hamptons home is valued at $1 million and the rest of the Florida resident’s assets, which are all located in Florida, are valued at $5 million.  Then the Florida resident would not be subject to New York estate tax because the $1 million Hamptons home is less than the current New York exemption of $4,187,500.  It is irrelevant that his or her total estate is greater than the New York exemption.

So how does the Florida resident avoid New York estate taxation on his or her $6,000,000 Hamptons vacation home?  One option is forming a special residence trust and then gifting the property to that trust.  This removes the property from the individual’s taxable estate.  There are advantages and disadvantages to this option, which are not discussed in this blog post.

Another option is to place the home in a Limited Liability Company.  By placing the home in a LLC, the interest in the home converts to an intangible asset, which is not subject to New York estate tax (so long as the LLC is not carrying on an active NY business).  The potential savings from transferring the $6 million Hamptons home to the LLC? A few hundred thousand dollars ($510,800 to be exact).  One caveat to transferring the home to a LLC is that the LLC should be a multi-member LLC, as New York takes the position that if a LLC is disregarded for federal tax purposes (i.e., it only has one member), then it will be disregarded for New York estate tax purposes in determining whether the property is intangible or not.  This is based on a decision made by the NYS Department of Taxation and Finance in May 2015.

If there is valuable artwork or other collectibles in that home, then the Florida resident may want to consider moving that property to Florida, gifting that property, or transferring those assets to the LLC.  He or she could also lend that art to a museum or public gallery in New York for exhibition.  All of these options would remove the property from the New York taxable estate.

Also important in determining whether a Florida resident will be subject to New York estate tax are the deductions allowable for New York estate tax purposes.  In determining what expenses are deductible in order to determine the value of a Florida resident’s New York estate, any deductions directly related to (i) real and tangible property located outside New York and (ii) intangible property are disallowed.  For example, property taxes on a New York home would be deductible, but property taxes on a Florida home would not be deductible.  Funeral expenses, Executor’s commissions, and other federal deductions that are not directly related to real or tangible property located outside New York or to intangible property would be partially deductible based on a percentage equal to the value of property outside of New York compared to the total value of the estate.

After moving to Florida, make sure you know the value and quality of the assets you are leaving behind in New York. If it is determined that those assets are real or tangible assets and their value exceeds the New York exemption amount, then plan accordingly to move those assets outside of New York, gift those assets, or convert the assets to intangible assets.  The savings could amount to hundreds of thousands of dollars for your family.