Considerations in the Possible Liquidation of a Closely Held Entity and Other Alternatives (Pt. 4 of 4)

Jan 24, 2023 | Business Planning, General Estate Planning, IRS / Tax Guidance, Podcasts, T&E Administration

Part 2 of 4 of a deep dive into closely held entities:

“Considerations in the Possible Liquidation of a Closely Held Entity and Other Alternatives,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Travis Hayes, ACTEC Fellow from Naples, Florida. This is the final podcast in ACTEC’s four-part series about closely held entities. Today, we will wrap up the series by exploring issues relating to the potential liquidation of a closely held entity including audit, liquidation, valuation issues and considerations, partnership tax issues, and situations where it may make sense not to liquidate. Our speakers today are ACTEC Fellows Ann Burns from Minneapolis, Minnesota and Lou Harrison from Chicago, Illinois. Welcome, Ann and Lou.

Lou: Thank you, Travis. We start with the point in the partnership where we’ve been successful in setting it up. We have observed all the formalities and the requirements to avoid, of course, those nasty Sections 2036(a)(1) and 2036(a)(2). Our clients have understood what is required with regard to the partnership and compliance going forward. And we take a deep breath and we’re very satisfied with where we’re at. The partnership is in place and operating as intended in our structure. And Ann and I are going to explore in this podcast what we should do as practitioners.

Closely Held Entities: Ongoing Role of Estate Planning Advisor

And we start off by saying these partnerships that are in place, what’s our role going forward? And I know a lot of us at certain points would like to take a step back and just assume that our clients and their advisors are handling the compliance on the correct front. But in 2022 and going forward, we start by saying for all our partnerships, let’s take a survey of what we have out there, and let’s get back involved in the structure and the compliance going forward so that we can actually improve and make sure what we set up is going to be successful. So, that’s not as easy as one would think.  And Ann, when we look at that, and we say we’re going to get back involved, what are some of your thoughts and steps for us at this point?

Ann: Well, thanks Lou. One of the things that we always tell our clients is that every estate planning strategy is not a one-and-done, put-it-on-the-shelf kind of thing. Like GRATs and sales to grantor trusts. Family Limited Partnerships and LLCs are living, breathing, estate planning strategies that need to be reviewed on an annual basis. Sometimes our clients are reluctant to have us be involved in that process. They think it’s expensive and time-consuming and sometimes they do that kind of a review with their CPA, their tax preparer, and their investment advisor, and that’s okay too. But there are legal issues that we should be involved in as well helping them review the documents, review the process, review the partnership agreements, and the capital accounts, and the K-1s, and the other compliance issues on an annual basis along with their tax preparers.

Because occasionally, just like sending out Crummey Letters, things don’t get done the way we expected them to get done or in fact, instructed our clients to do. So, sometimes where clients are a little reluctant to have that annual review, I find that the advisors can be your best friend in helping this happen. Because when you talk to the advisors about what needs to happen and say, “I assume you’re taking a look at the capital accounts each year,” they say, “Umm, no, I hadn’t thought to do that. Tell me more about it.”

So, as a team, if we can do this annual review, we can help the clients understand that their partnerships and their LLCs are not only important to get set up properly in the beginning, as you talked about Lou, but they need to be administered properly as we go through the years.

Closely Held Entities: Assessing Administration and Compliance Issues

Lou: And among those items Ann, when we do the compliance and we see are not done correctly? We’ll just make a laundry list of the most obvious ones that occur: non-prorata distributions, K-1s that don’t match up with the percentages that are actually owned by the parties, capital accounts that do not reflect additional capital contributions, incorrect titling of assets that are supposed to be in the partnership or management of the partnership inconsistent with the partnership agreement. And so, we coordinate with the accountants and to some extent with the clients, and we see that we have these problems.

And I think our first instinct is: “oh wow, we’re going to have to do something going backward to correct this.” And after you take a deep breath, the reality is assessing a mea culpa and saying yeah, we, the general partner did this wrong, but we’re going to do it right going forward. We’re going to correct for non-pro rata distributions or capital accounts and making adjustments going forward is certainly tolerable and sensible down the road. So, it’s not a stage where we need to panic because the administration is incorrect, which is something that we all see often. But it’s a matter of addressing it going forward and doing the best we can with that information but getting everybody involved.

Getting the accountant involved and the client and other advisors. And at this stage, we’re looking at the administration. We’re fixing the administration to the extent we can going forward, but we as advisors, are also looking at 1.) what we accomplish by the partnership and, 2.) how, ultimately, is it going to look on an audit down the road? And so, we’re assessing at this stage how troubling the incorrect administration really is. Is it just a one-time thing or is it just complete ignorance of all formalities? And Ann, when we assess that situation, what are our possible conclusions at that point?

Ann: So, I think that’s right, Lou. There are some things that are so easily correctable. You find that one of your K-1s is wrong in a given year or the non-pro rata distributions, for example. That can be fixed in a way by saying maybe those distributions or the cash that came out to one partner and not to the other partners was in fact a loan and we’ll document it as a loan, and they’ll pay back interest and things like that. So, where it’s correctable, remediation is a great way to go.

Another example, as you were ticking through things, sometimes our partnerships – contrary to our advice – sometimes our partnerships do include personal use items like cabins and lake homes and the condo in Florida. Where there’s personal use, that needs to be accounted for. So, some of those things can easily be remedied. Where we find that we have partnerships that really have crossed over the line. They either were set up improperly. They haven’t been administered properly for years. And whatever our issues are that we can’t continue, then we’re going to start looking at options that are either fall into a category of give it away or sell it, or liquidate it or terminate it.

And before we get into the liquidation and termination, let’s spend some time talking about one of our options is to, for example, for a senior generation that is holding onto a large portion of partnership units, either the GP or the LP, we can look at the strategies that we’ve used before. Straight outright gifting into trusts, sales to grantor trusts, and so on, to use as options to remove those assets from the senior generation estate. Also, the thing that we’re thinking about is what is the senior generation’s partners’ estate tax returns going to reflect when they die.

Are we going to share that they still own partnership units, and then that’s going to probably be a big audit issue. We’re never really going to get away from answering “yes” or checking “yes” on the estate tax box that says did you transfer any interest during your lifetime because in fact, when they created the partnership and made gifts or made sales early on, they did that. And so, doing additional sales or additional gifts at this time isn’t going to exacerbate that issue. But we can get the partnership units, the limited and the general, off of the estate tax return.

So, let’s talk maybe a little bit more about gifting. You were saying, for example, the annual exclusion, the lifetime exemption amounts, whether by a sale to a grantor trust or transferring LP units to a GRAT. Using LP units in a GRAT situation is usually a little bit less attractive because when we make out annuity payments, we’re required to appraise the value of the units every year. So, that gets to be often time-consuming and expensive, and clients aren’t willing to do that. But with annual exclusion gifting or lifetime credit gifting, that can be very advantageous. Anything further Lou, that you want to talk about in connection with making these kinds of gifts or sales?

Closely Held Entities: Termination and Liquidation Considerations

Lou: I agree with your summary, and sales to a grantor trust are still one of the most effective ways to reduce the estate tax. I know our clients have done a lot. Initially with setting up the partnership, we’ve done a lot. But coming back and looking at what we still have and trying to make that less desirable on an estate tax return for an agent to audit and eliminating it altogether from the estate tax return can be very advantageous for these partnerships, as you mentioned. They haven’t been complied with very well. We may get to a point where we just look at it and say, we’re best off terminating the partnership.

Taking the gains that we’ve achieved on the estate tax side with transfers we’ve already made and just taking it out of the equation as well. So, the final point for this podcast is the termination of a partnership. And two concerns here. One is – or two items. One is we may want to do it because the partnership has been administered so faulty that we just want it gone. Or there may be an income tax reason that we want this partnership removed,  terminated, from existence.

From the faulty side, and even if we want to do it for income tax reasons, the first item is, to make sure we get the accountant involved, and generally, there are no income tax concerns when we are distributing assets to the partners except when you get a little too creative and you’re distributing certain assets to certain people and other assets to other partners. You may run into some problems, and we’ll throw sections out under Section 737, or even 704, of the code and that’s why it’s incredibly important to get the accountants involved. On that point, Ann do you want to add just a couple of more comments on the sending the wrong assets to the wrong partners?

Closely Held Entities: Mixing Bowl Rules

Ann: Yeah, let’s do it. So, what Lou’s referring to is something that we often refer to as the “mixing bowl rules.” And so, what happens here is that if one partner puts into the partnership – an appreciated asset like a building- a commercial building- or some other equipment or other kinds of asset that has appreciation. So, the contributing partner has a low basis and a higher value, and another partner, for example, puts in cash, if within seven years, and generally the safe harbor is seven years, if the contribution to the partnership has been sort of old and cold inside the partnership for seven years, then those rules don’t usually trip us up.

But within that seven-year period, if we distribute pro rata to both partners, let’s say half the cash and half the building, we’re going to trigger a gain to the contributing partner who contributed the appreciated asset. That partner is going to be treated as if they sold half of that asset to the other partner. So, we don’t want to trigger this kind of gain when we make our pro rata distributions on liquidation. So, we like to kind of keep in mind two timeframes when we’re thinking about liquidating or terminating a partnership. The first one is a two-year statute of limitations – actually two to three years – which is, your gift tax statute of limitations.

In other words, when you made gifts of the partnership interest and filed your gift tax return, reflecting those gifts, there’s a three-year statute of limitations on that gift tax return, which begins running with the timely filing of that return, if you make full disclosure of all of the relevant information related to the gift. So, we like not to liquidate the partnership within that three-year statute of limitations or at least two years into the statute of limitations. And then the second timeframe is this seven-year timeframe that relates to the mixing bowl rule. So, you do want to be very careful when terminating a partnership and distributing assets to the partners.

This is where, Lou, your advice is excellent, which is to get the CPA involved. And if you’re lucky enough to have a partnership taxation partner in your firm or someone that you know that you can go to on this, these rules are very complex, and we’ve only discussed them at a very high level. The mixing bowl rules have lots of exceptions, and exceptions to the exceptions. But that’s the general gist of it. So, keeping in mind those two timeframes is very helpful when considering whether to terminate a partnership or not.

Closely Held Entities: Termination

Lou: And in that regard, Ann, for all of us, let’s not be scared of termination because when you do follow the rules, you will be able to terminate without triggering a gain. And termination can be very effective, not only to eliminate the partnership from the estate tax return but – and this is the final point we’ll talk about.  For those partnerships that really are not serving any further purpose, keep in mind that if you’re holding a partnership and you’re getting an estate tax discount for that, you’re going to have a basis equal to that discounted value.

If you set it up when the exemption was $2 million and you had a relatively smaller estate and now we have an exemption at $12 million, you may no longer need the partnership for estate tax discounts and you certainly don’t want to have that sort of step-down in basis at that. So, it’s also a good time, even for effective partnerships to see if it still fits within the overall estate planning for your client.

And with that, we’ll say that there’s a reminder for everybody that if you have partnerships that you set up that you haven’t monitored in a while or basically are afraid to look at what’s been transpiring since you set it up, now is a great time to truly revisit your partnerships, assess the risk compliance, consider additional planning and consider steps that you may want to take further to make sure you have a successful partnership strategy. And Ann, would you like to add anything?

Closely Held Entities: Future Generations

Ann: I think the only thing I’d add is I really like what you said, Lou, about assessing it because sometimes these partnerships can be very advantageous to family members. Remembering that it’s the senior generation was the one that created it. They’re the ones that might have the 2036 estate tax inclusion issues that Lou referred to earlier, but the next generation doesn’t have those issues.

And so, if a family does decide to keep a partnership intact, there are good reasons for that because the next generation can – assuming the compliance is handled well – the next generation might be able to continue the benefits of the partnership on down the line. There are definite pros and cons. As you said, Lou, pros and cons at each generation and so, the decision about whether to terminate or keep the partnership intact is a complex one and should be reviewed with the entire estate planning team.

Lou: Thank you. That is a great point and wish everybody good luck in their partnership planning.

Ann: Thanks, Lou.

Travis: Thank you Ann and Lou for presenting as part of ACTEC’s podcast series on closely held entities.

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