Dissolving an irrevocable trust and moving inheritance into an LLC

[wh2oh]

My mom recently passed away. We (her and 3 siblings) created an irrevocable trust 3 years ago to place her assets in there during her lifespan. The assets involved a couple of pieces of property (a residence and a leased commercial building) and some cash. The total value is well under the estate tax limit, so no estate/inheritance taxes are involved.

Now that she has passed away, we (siblings) are looking at dissolving the trust in order to officially split the assests equitably. We get along, but have different long term plans for our inheritance. 2 of the siblings would prefer to continue owning/operating the commercial property and 1 would prefer outright ownership of the residence. The estate's accountant has suggested forming an LLC as a means to protect the assests, etc.

We (the 3 siblings) are trying to sort out what would be best. I have some questions that are a little long winded, but am hoping some of you would enjoy taking a crack at any, or all, of them. We will be talking to an estate laywer towards the end of October, but am hoping to get some professional opinions prior to then (e.g., do my research!). This seems to be a great place to throw out some of these questions, and maybe someone else will also benefit from the responses.

Here are my initial questions on this matter:

1. Is it fair to assume any/all cash distributions from the irrevocable trust to the beneficiaries will not be taxed but will be considered inheritance? This would be in reference to the liquid assets that will be distributed to the heirs
at the dissolution of the irrevocable trust.

2. The current thought is that all inheritance property would be placed into the LLC with an additional cash amount of say $10,000 - $20,000 for operating capital/expenses. What end-of-year tax consequences will each member need to know about the LLC structure? For example, if there is profit in the LLC at year end, which there likely will be, how will that affect each individual? Or what capital gains/etc. will occur? What advantages/disadvantages are there with an LLC structure?

3. What would the future consequences be should the members decide to dissolve the LLC - will there be a huge tax bill?

4. If the property is sold while in the LLC, what consequences would that have for the members? Would capital gains only apply for any dollar value increases from the properties base value when the property was 1st inherited compared to when it was sold?

5. Can the members have other entities within the LLC besides us, such as other trusts, corporations, etc.? Would these other entities have be Texas entities (currently the trust is in Texas, whereas the siblings live in Texas, Washington State and Hawaii)?

For now, these are my starting points of interest/confusion. Any help or response will be greatly appreciated. I promise not to hold anyones feet to the fire, I'm just trying to prep myself and my brother/sister so that we have a better understanding of the LLC and the consequences of transferring inherited property into it.

Or, any other suggestions?

Will

 

[tranquility]

1. Is it fair to assume any/all cash distributions from the irrevocable trust to the beneficiaries will not be taxed but will be considered inheritance?

No. None of it is an inheritance. It was a contingent gift when the trust was funded.

2. The current thought is that all inheritance property would be placed into the LLC with an additional cash amount of say $10,000 - $20,000 for operating capital/expenses. What end-of-year tax consequences will each member need to know about the LLC structure? For example, if there is profit in the LLC at year end, which there likely will be, how will that affect each individual? Or what capital gains/etc. will occur? What advantages/disadvantages are there with an LLC structure?

Part of the answer to the question involves your state. Don't forget compliance costs.

3. What would the future consequences be should the members decide to dissolve the LLC - will there be a huge tax bill?

All this dissolving going on. The consequences of winding up a corporation depend on the facts. We have none.

4. If the property is sold while in the LLC, what consequences would that have for the members? Would capital gains only apply for any dollar value increases from the properties base value when the property was 1st inherited compared to when it was sold?

Nope. The trust's (and eventually, the beneficiary's) basis is the same as mom's when she made the gift to the trust. Also, by putting it in the irrevocable trust, section 121 will not be available for the sale of the personal residence.

5. Can the members have other entities within the LLC besides us, such as other trusts, corporations, etc.? Would these other entities have be Texas entities (currently the trust is in Texas, whereas the siblings live in Texas, Washington State and Hawaii)?

Yes, you can have others, no they don't have to be from Texas. But, you have no idea of the problems you're getting into. Interlocking entities are not appropriate if you don't know what you're doing.

Or, any other suggestions?

You might interview a malpractice attorney to review the reasoning as to why mom put the assets into an irrevocable trust. If it was not for medicaid planning purposes, that decision cost the beneficiaries of the trust a TON in taxes.

 

[wh2oh]

Tranquility,

Thanks so much for such a quick reply. The irrevocable trust was set up for medical/medicaid planning, at the advice of an estate planning attorney. The trust basically states that the assests are to be split, per stirpes between the immediate living heirs, and then so on.

Am I correct in understanding that once the properties were put into the trust, and following the death of the grantor, any/all subsequent distrubution(s) of the assests (property and cash) will be subject to taxes?

 

[tranquility]

No. Distributions of corpus are not taxed. Income of the trust is either taxed at the trust (usually bad idea) or with the partner. That could depend on if the trust is simple or complex and what the trust's terms are.

Did she ever use medicaid?

 

[wh2oh]

No, we never got to the point of using Medicaid. We set up the trust with some expectation she would live a number of years beyond the look back period of the trust. Between some long term health insurance and cash on hand we figured she would be well covered for the 5 years, and were mostly worried about high health care costs if she became convalescent or had extremely high out of pocket expenses.

The terms of the trust were simple, not complex. The eldest sibling has been the administrator since it's start date. The intent of the trust was for asset protection, and to provide for our Mother's care for the course of her life. Rental (lease) income came in from the commercial property, then went out to pay for her health care costs. The administrator essentially has all the standard duties, including the ability to sell assets, re-invest, etc. Also, the standard language is there for providing for education expenses of the children, grandchildren, etc. It's a pretty simple, standard trust. It does not stipulate any particular property division other than - per stirpes. I believe the life of the trust is up to the 35th birthday of any of the grandchildren, which would be about 20 years from now.

Would it then make more sense to first determine the value of the assets while under the trust, then distribute the assets per stirpes either during the life of the trust or by dissolving the trust, then let the individuals place their assets back into an LLC if they so choose?

Tranquility - I truely appreciate your responses and advice. Will

 

[tranquility]

The terms of the trust were simple, not complex.

Are you sure? See, TaxAlmanac - A free online tax research resource and community - Guide to Types of Estate and Trust Entities

Would it then make more sense to first determine the value of the assets while under the trust, then distribute the assets per stirpes either during the life of the trust or by dissolving the trust, then let the individuals place their assets back into an LLC if they so choose?

Since the distribution is irrelevant to the taxation issues, I don't see why not.

But, I'd wait to see what the trust says. You don't get to decide, the trust does.

 

[wh2oh]

I guess the term simple doesn't really mean simple when it comes to what I think simple means! I was thinking simple in that we did not have a lot to distribute. I'm looking at the trust and would now call it complex!

I'm reading the statement regarding termination, and it seems a bit ambiguous other than it cannot terminate until the death of the Grantor, which makes sense. Issues of termination we can sort out with the attorney who set it up.

The other section I'm trying to interprete would be Withdrawal Rights, where is seems to indicate that each of the Donee's have the right to withdraw cash or other property on a cumulative basis up to their equal share of the gifts made to or for the benefit of the trust. That is what it seems, but this section is about 1 1/2 pages long and gets a bit confusing during the 1st, 2nd and 3rd read. I'll get into it a little deeper this evening.

When we started this thread, you mentioned perhaps being liable for a TON of taxes. Where do you forsee these coming from?

 

[anteater]

When we started this thread, you mentioned perhaps being liable for a TON of taxes. Where do you forsee these coming from?

Without going back and reading it all, I believe that Tranquility was referring to capital gains tax if the property is disposed of. An irrevocable trust is a prime tool in Medicaid planning. But, what is given up is the step up in cost basis that the trustor's property would normally receive upon the trustor's passing. The property in the irrevocable trust continues to carry the trustor's cost basis.

(Which, I think, accounts for Tranq's allusion to legal malpractice.)

 

[wh2oh]

Thanks anteater,

If I recall a previous conversations with my sister's husband, I'm thinking the cost basis of the property was established about 3 years prior to the date of when we set up the irrevocable trust. That would have been at the time my Father passed away. If I recall correctly, I believe when we probated his will that would have established the cost basis of the property at the time she became the sole owner. Just to complicate things, now that I think about it, she actually inherited the commercial property from her Mother some 40 years or so ago. I think the property deed had always remained in her name, but I'm assuming it still would have been community property, thus why the cost basis was re-established at the time of his passing.

But, back to your reply, I'm thinking what you are telling me is that - If the property has not gained in value since the trust was set up, then there would definately be no capital gains tax. However, if the property has gained in value, then CG taxes would apply.

Would any gain in property value(s) be exempt from CG due to it being inheritance? As an example, say the property was worth $100,000 3 years ago when the trust was established, and now it is worth say $200,000. The difference being + $100,000. Would the $100K be subject to CG, or would the property get a new cost basis at $200K since it is being passed on to the heirs and is under the estate tax limits?

Whew! Thanks again for your thoughts on the matter. ~Will~

 

[tranquility]

The basis is not stepped up. You did not "inherit" the money.

None of it is an inheritance. It was a contingent gift when the trust was funded.

Your basis will be mom's basis in the property.

I'd also check the basis reasoning on dad's death if it wasn't done by a professional. Community property titling issues can make things interesting (if CA).

 

[curb1]

Distribute the assets and be done with this. It is not worth the hassle you are going to have.

 

[wh2oh]

Thanks again all,

Just to double check and make sure I understand everything so far - will mom's basis then be set at the time the trust was established, or at the time of her death? I believe the answer is - At the time the trust was established, that there would not be a step-up to the cost basis. This is actually very important as 1 of the properties has appreciated dramatically (even in this economy!). The property had a slow but modest gain over the course of the first 2 1/2 years, then a significant gain shortly after her death (within the last 6 months)(due to development of nearby properties).

As for distributing the assets and being done with this, these properties have been in the family for a long time (100 years and 40 years). We are not too keen on liquidating these into cash, only dividing them up within the immediate family members for their use. I suppose this could be easy, or difficult, and that is why I'm asking the questions, to try and get a handle on the facts, options and even opinions. Also, if we're lucky, someone may read this someday and have a better understanding of any traps, pitfalls, pros and cons that might occur when setting up an irrevocable trust, which a lot of people are doing these days. Our fortune is that we get along and are not trying to contest or undercut the other.

So, the key points the way I understand things so far are:

1. That the trust is simply a gift made by the Grantor and can/will be distributed according to the conditions of the trust. The word inheritance really should not be used when discussing the trust.

2. Since the trust states it is initially intended to be for the immediate descendants (us 3), and is to be divided per stirpes, then whatever the assessed value of the trust is, is how the trustee would/should decide what the value each is entitled to. I'm assuming that can be done by anything from a handshake agreement between the siblings, up to utilizing property appraisals, etc.. Whatever the agreement is, it should be put in writing in order to clarify any unintended problems.

3. I believe the trust can be terminated at any time now that the Grantor is deceased, but we will need to verify this with the attorney that put it together.

4. If either property is sold at this point in time then there may be tax consequences, related to capital gains, based upon Mom's cost basis.

5. The part I am still not clear about related to this are - 1) If the assets are distributed to the siblings, and not sold outright, at what point does the cost basis began? and 2) How does one go about determining the cost basis at a particular point in time (say 3 years ago, versus 6 months ago, versus today)?

6. I'm assuming that if the property is not sold, but instead distributed to each successor (immediate child), then Capital Gains taxes would not actually kick in unless/until the successor sold his/her portion of the property. Then CG would then be assessed based upon the cost basis at that point in time when the successor received the distribution versus the point in time when he/she sold the property.

The rest related to the LLC is another, and much more complicated, topic altogether - so I will not go any further with that in this thread.

Again, I would like to express heartfelt gratitude for everyone's time in helping me understand this a little better. I'm a much better mechanic than I am an attorney. My Dad was an attorney (Civil) and at one time a municipal court Judge in Austin. I surely wish he was around to answer my many questions! ~Will~

 

[curb1]

I didn't suggest distributing, selling and turning to cash. Distribute the assets to beneficiaries and let each do as they wish with the assets. That doesn't mean selling the assets unless the holder of each asset desires to sell. Keep it simple.

 

[tranquility]

Just to double check and make sure I understand everything so far - will mom's basis then be set at the time the trust was established, or at the time of her death? I believe the answer is - At the time the trust was established, that there would not be a step-up to the cost basis. This is actually very important as 1 of the properties has appreciated dramatically (even in this economy!). The property had a slow but modest gain over the course of the first 2 1/2 years, then a significant gain shortly after her death (within the last 6 months)(due to development of nearby properties)

Basis will be set at the time she funded the trust. That is the moment of the gift. The receiver of a gift takes the basis of the donor. (With minor exceptions not relevant here.)

The real problem will be the commercial property. That basis was set 40 years ago. I suppose, if you live in a community property state, the community could have gained some ownership rights to mom's separate property. (Inherited assets are separate.) That is unlikely unless community funds were used for improvements or to pay down a mortgage. Even then, proving up how much rights the community has gained (to get a step up at dad's death) would be problematical at best.

I'd also look to see if the house was titled as joint tenant with right of survivorship, or community property with right of survivorship (if CA) at the time of dad's death. Many people screw this up and only get a step-up on the 1/2 inherited.

1. Essentially, yes. Except, the funding of the trust (transfer of ownership to trustee) is the gift. Many set up trusts "in case" and never fund them. Even if the property is listed in the trust, if the titling was not done, the gift was not made. (Absent extreme facts to indicate the lack of titling was a mistake.)

2. You read the trust, I did not. I have no idea. Usually, the easiest way is to put everyone on all titles and to distribute funds appropriately. The beneficiaries can certainly negotiate and trade rights before distribution and if the trustee agrees, the agreement can be done without tax consequences. The trustee will not be protected by a fiduciary breach by a written agreement by the beneficiaries. It may estop the other parties from making certain claims, but that is it.

3. Yup.

4. Yes.

5. The basis is. It does not begin, it just is. As to how to determine it, it depends on the facts. Each basis would be determined in the manner appropriate. Basis calculation will be a job for a professional.

6. Capital gains are not realized until the item is sold in this case. The amount realized when sold (price), less the basis is the capital gain. (The cost to sell the item will also reduce the gain.)

 

[anteater]

Per stirpes does not mean "equally."