Partners with Different Wants and Needs

Roger and three partners own a well-maintained 80-unit apartment complex that they developed 17 years ago. The property is free and clear of debt and virtually all of the depreciation deductions have been taken. The after-tax return on the current equity is MUCH lower than acceptable to the partners and Roger is ready to be out of the management. The great news is that there is a buyer ready to offer $4 million for the property. The bad news is (1) they own the apartments in a limited liability corporation (LLC) and (2) their basis in the apartments is down to $500,000. A sale will result in total state and federal taxes of more than $700,000. Roger is willing to pay his taxes to be relieved of the management responsibility. One other owner with a minority ownership has losses sufficient to eliminate any tax consequences of a sale. The other two investors do not want to sell and accept the tax consequence. Combined, these two investors own more than 50% of the LLC. Because the property is owned in an LLC, it is not possible for the two owners to complete a 1031 tax-deferred exchange on their portions of ownership. It would appear that these partners are at cross-purposes.

NOT NECESSARILY! Roger is willing to pay his taxes. One minority owner has losses to balance his gain. What about the other two owners? PRIOR TO ANY CONTRACT TO SELL THE APARTMENTS, each of the other two owners could establish individual self-directed tax-exempt trusts. (If you read my article in the last issue of the Observer, you know that a self-directed tax-exempt trust is a CHARITABLE REMAINDER TRUST.) Simultaneously, they would each establish a wealth replacement trust to pass on the value of their ownership to their heirs TAX-FREE IN CASH. These trusts are easy and inexpensive to establish and maintain. Each would transfer their LLC ownership into their individual tax-exempt trust prior to the property being sold for cash. The net sale proceeds portion due to each of the trust owning investors would flow into their trust and NOT be subject to tax. Each investor, being the director of their individual trust, would designate how those proceeds are to be reinvested. The trust owning partners will only pay tax on the income they take out of their trusts. Everyone can achieve his or her separate objective.

The above is a relatively simple example but illustrates the concept. There are a variety of situations to which the concepts in the above example will apply. One of the more common situations is where family members have inherited property or a business and retained ownership long enough for there to be a significant taxable profit upon sale. A real situation involving a ranch in Florida included nine family members from three branches of the family ranging in age from 39 years old to 84 years old. There was considerable animosity among several of the family members and a clear division between the three owners over age 70 and the six owners under age 55. There was an all cash full price purchase contract readily possible for the subject ranch. The solution was to identify which family members would pay their taxes to receive the cash and which family members would only sell if they avoided the taxes on the sale. Four family members opted to pay the taxes and receive the cash. The five youngest family members all chose to establish self-directed tax-exempt trusts and companion wealth replacement insurance trusts to totally avoid the tax on sale. One important factor was that once everyone made their choice and trusts were set up for the five youngest family members, none of the family members had to ever communicate with any of the other family members again.

A third example would be a father and son who jointly own a very successful business in Michigan. A substantial portion of the asset of the business consisted of nearly free and clear real estate. The father, who was in his 70’s, was already semi-retired and wanted to fully retire from the business and sell his portion of the business. The son, who ran the business full-time, wanted to simply mortgage the company real estate and buy back the company stock from the father. Their legal advisors organized that action, but the tax advisors indicated that the father would pay more than $1 million in taxes on the transaction, plus he would still owe estate taxes on the balance of the sale proceeds upon his death. The solution was to have the father place his 45% of the corporate stock into his self-directed tax-exempt trust prior to the corporation buying back the stock. The father also established a companion wealth replacement trust, which will provide the tax-free cash resources for the son to repay the property debt when the father passes away without the problem of probate.

It is imperative that competent and EXPERIENCED legal, tax, financial planning, estate planning and other investment advice be obtained when considering the use of a SELF-DIRECTED TAX-EXEMPT TRUST (CRT) in any such situations as described above. The two-question approach is highly recommended when seeking such advisors. The first question is, “Are you knowledgeable of the use of charitable remainder trusts with real estate and/or business dispositions?” The second question is infinitely more important. It is, “HOW MANY SUCH TRANSACTIONS HAVE YOU HANDLED IN THE PAST YEAR?” There are many advisors who know the rules, can review the rules and/or may have had some training or education in handling property and/or business dispositions using charitable remainder trusts. Unfortunately, there are very few who actually have experience and know HOW TO use these trusts in practical application for their client’s benefit. Making the effort to find experienced advisors is WORTH THE EFFORT. For those moving from active investment ownership to passive investment ownership that do not want to pay a tax in order to make that change, a SELF-DIRECTED TAX-EXEMPT TRUST (code word for Charitable Remainder Trust) should at least be considered.

One last comment about reinvesting assets inside of a self-directed charitable remainder trust is important. THE ASSETS CAN STILL BE INVESTED IN REAL ESTATE. The concept is to make the move to more passive real estate investments WITHOUT having to pay a tax or go through the problem of separating partners to be able to complete a Section 1031 exchange. Please note that the trusts discussed in this article are all designated as “SELF-DIRECTED.” Using these trust strategies does not mean that one must give up all control of their assets or income during their life and there is no gift to charity until the current owners have all died. Probably as important to some property and business owners is that they can pass on 100% of the value of their accumulate assets to their heirs TAX-FREE IN CASH.

In the next issue, we will explore how to use a self-directed tax-exempt trust to accomplish the disposition of property or businesses owned in a regular “C” corporation. The “C” corporation presents a particular problem because of the issue of double taxation.

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