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When structured correctly, the exchange of real estate property using closely held business entities can result in advantageous tax treatment under the Internal Revenue Code of 1986, as amended (“IRC”), while simultaneously insulating the owner(s) from liability from potential judgment creditors. Section 1031 of the IRC, known as the “like-kind” exchange section, begins with the following statement: “[n]o gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.” If the requirements for a like-kind exchange are met, this provision allows owners to defer the recognition of gain on appreciated real property if the real property is exchanged for replacement real property of “like kind”. Put differently, if an investor is looking to acquire real estate and also dispose of current real estate holdings, the immediate need to pay federal or state income taxes on the gain that would otherwise result from the sale may be postponed through a like-kind exchange.
§ 1031 Requirements:
The above definition contains several essential components that must be met for a transaction to qualify as a like-kind exchange. The following is a brief outline of the more material of these factors:
- There must be an “exchange of property.” A simultaneous swap of real property will satisfy this requirement. The exchange may also be a deferred exchange (meaning the current disposition of property and later acquisition of the like-kind property) or a reverse exchange (meaning the current acquisition of property and later disposition of like-kind property), but additional rules and requirements will apply to these transactions, including the need to use a Qualified Intermediary for deferred exchanges and reverse exchanges, and the need to meet strict time frames for the identification and acquisition/disposition of the replacement property.
- The property must be “held for productive use in a trade or business or for investment.” While no definite time period meets the “held for” criteria, the longer the property is used in a trade or business, or held for investment purposes, the greater the likelihood that the transaction will qualify for the §1031 exchange. With limited exceptions, the IRS generally takes the position that personal residences and vacation homes do not qualify for like-kind treatment.
- The properties to be exchanged must be of “like-kind.” The IRS will consider the nature of the properties involved to determine if the like-kind requirement is met. Exchanges of most real property will qualify for like-kind treatment (e.g. the IRS has considered vacant land similar enough to improved land to qualify for a like-kind exchange). To the extent the investor receives cash or other property that is not like-kind, the IRS will require recognition of gain and payment of the resultant taxes.
Real Estate Transactions Using LLCs:
Many investors choose to structure their real estate transactions by setting up limited liability companies (“LLCs”) or other closely held business entities, and purchasing real property through such entities. Assuming an LLC is properly created and maintained, and its member(s) do not elect to classify it as a C-corporation for federal income tax purposes, the LLC form can insulate its member(s) from liability from potential judgment creditors while allowing pass-through taxation. Pass through taxation results in only one set of taxes for the individual member(s) (or shareholders if S-corporation classification is elected) (as opposed to C-corporations that are taxed at the entity level and again at the shareholder level when distributions are made).
Additionally, holding each property in a separate LLC can reduce the exposure to risk for investors owning multiple properties in this manner, which can result in significantly more favorable loan terms. For example, a creditor who obtains a judgment against the real property owned by one LLC where the fair market value of such property is insufficient to satisfy such judgment cannot reach either the personal assets of the owner(s) of such LLC or personal assets of the other LLCs, and cannot reach the properties owned by the other LLCs in an attempt to satisfy its judgment. The insulation from risk created by the separation of ownership of the property creates an incentive for a lender to provide better loan terms, particularly when the loan is collateralized by a portfolio of properties owned in this manner.
§ 1031 Exchanges Through Single Member LLCs:
In Florida, individual investors or entities may form Single Member LLCs (“SMLLC”) to own particular real estate assets. While SMLLCs do not provide all of the protections of multi-member LLCs, a sole member of an SMLLC may receive like-kind exchange tax treatment for the exchange of either 100% of his or her membership interests in, or the real property owned by, such SMLLC for either the real property owned by a third party entity or individual, or the membership interests of a third party’s SMLLC that holds replacement property. This result is possible because the SMLLC is “disregarded” for federal income tax purposes as an entity separate from its owner; that is, federal tax law simply ignores the existence of the entity, instead treating all of the assets as owned directly by the sole member. Consequently, an investor may also receive like-kind exchange treatment if all of the § 1031 elements are met and the investor sells property owned by one of its SMLLCs and acquires replacement property using another of its SMLLCs as a part of the same transaction (or deferred or reverse like-kind exchange, as applicable).
With the economy rebounding and real estate prices on the rise, like-kind exchanges should again become a prevalent tool in effective tax planning for real estate investment activity. However, tax planning for real estate transactions often involves a complicated analysis of all applicable factors and should be tailored to each individual’s situation on a case-by-case basis. Additionally, the IRC, the Treasury Regulations promulgated thereunder and other IRS publications contain certain exceptions and guidance on how to accomplish like-kind exchanges. The above is not intended to provide legal, financial or tax advice—it is only a brief outline of how like-kind exchanges under the IRC may provide owners with an opportunity to defer recognition of taxable gains for significant periods of time. Owners should always consult with a qualified attorney to assist in analyzing and structuring their proposed transactions to take full advantage of the protections and savings afforded by applicable law.
One of the most common errors parents can make when doing their estate planning is not making the hard choice as to who they want to serve as their fiduciary. Specifically, parents make the mistake of choosing among their children to serve as their fiduciary instead of choosing a bank or brokerage company with trust powers, or other non-family member.
Parents naturally do not want to show favoritism with regard to their children or indicate they lack any confidence in any particular child. Often, the parent kicks the can down the road by simply choosing both of their kids, or even multiple siblings as co-fiduciaries, even knowing that they may have great difficulty working together. This is a disastrous road to take. Parents should not set their children up for failure if they know their children are not likely to be able to work together.
The following is the most common scenario. Mother, being the last to die, changes her will to make her two daughters co-personal representatives of her estate and co-trustees (replacing her deceased husband who she had named in her prior will). One daughter is strong-willed, the other is mild mannered. The daughters often had problems working together and even routinely fought as youngsters. The mother, however, simply cannot bring herself to choose between her daughters. As such, she wants to “recognize” both by making both daughters co-fiduciaries of her estate or trust. The result? The daughters, predictably, cannot work together and worse, actively take action to hamper and frustrate the other when they need to work together the most. After the mother dies, all gloves are off and the daughters start litigating. The result? Tens of thousands of dollars of the mother’s estate intended to go to the benefit of her daughters is squandered in legal fees—all because the daughters were set up for failure by the mother in her estate plan.
What is the solution? If your estate exceeds $1,000,000, a bank or brokerage company with trust powers is a good solution. A professional fiduciary such as a bank or brokerage company can offer professional fiduciaries familiar with Florida law and who know how to navigate an estate administration and/or trust administration. Having lost a parent is difficult enough, but having to administer an estate or a trust by a person unfamiliar with fiduciary responsibilities can be a burden that may not be appropriate for your children. Moreover, by picking a bank or brokerage company, the parent avoids having to choose between their children so that no one is upset. In essence, you will have given your kids a final gift of having a professional navigate the administration of your estate plan.
If your estate is less than $1,000,000, there are many smaller trust companies and/or certified public accountants that are willing to act as your trustee and/or personal representative. Family harmony can be an important legacy that you leave by considering the simple realities of your family dynamics. If in doubt, choose a third party fiduciary, not your family.
Orlando, FL – Often when a closely-held business (i.e. a non-publicly traded LLC, Partnership, or Corporation, hereinafter “Family Business”) is created there is a single shareholder who owns 100% of the voting units and thus makes all of the decisions concerning the business (hereinafter the “Founder”). As time goes on and this person ages, they will begin to think about their goals for estate planning, as well as what they would like to happen with the business when they are gone.
Generally people tend to favor splitting up all of their assets equally among their descendants. However, when the largest asset is the Family Business, resolving these matters may become very complicated. For instance, it is common that certain children will be involved in the Family Business, while others have nothing to do with it. Further, between the children who are involved in the Family Business, there will often be different degrees of involvement, skill, and dedication. Other issues that frequently arise involve children who have substance abuse problems, or mental health issues. Additionally, there is always the possibility that one or more children will go through a divorce, which could create the risk of ownership of the company being transferred to an ex-spouse. It is also not uncommon for a non-family member to be involved in the Family Business. The Founder may wish to reward their hard work and dedication with partial ownership and/or control of the company.
The purpose of creating a unified Estate and Succession Plan, including a Shareholder Agreement (or Operating Agreement or Partnership Agreement, as the case may be), is to avoid as many of these issues as possible on the front end. Doing so is both good for the family and good for the business. By and large the most important issue for the continued success of the Family Business comes down to who controls the company. Therefore, it is often advisable for the Founder to recapitalize the Family Business into voting and non-voting units. This helps to facilitate the goal of the children having “equal” inheritances in terms of value, while ensuring the Family Business will continue to operate and prosper by allowing control of the company to be separated from the right to income generated by it.
The Shareholder’s Agreement is important because it creates the rulebook for governing the company and will be the foundation moving forward. Dividing control of the Family Business will depend on a variety of factors including the nature of the business, and the experience, age, education, and responsibility of the family members. There are many different ways to define control. On one end of the spectrum, one child will have total control of the Family Business (i.e. control of day-to-day business operations, and the right to do anything with the business that they please). This model works as a continuation of the one created by the Founder. However, the success of the company will depend solely on that one child, and this situation is very likely to create disharmony and friction among the family members. When voting power is shared among family members there can be many different arrangements.
Toward the middle of the spectrum, one child may have a majority of voting power, and thus that child will have control of day-to-day business operations. Other issues may be left to a majority vote, which that child would solely determine, giving them an additional level of control but not total control. And, certain “Issues of Major Importance” will require a “super majority” vote, so that at least one other child joins and agrees with the majority holder.
At the other end of the spectrum, one child may be given 50% or less voting power, and have control of day-to-day business operations as president or director, but other items will be put to a majority or super majority vote, depending on the particular issue.
There can be many Issues of Major Importance, depending on the nature of the business and how the voting control is divided, but often the issues that will be put to a majority or super majority vote include the following:
- Sale or disposition of substantially all of the company’s property, or of any property in excess of a certain value;
- Entering into a lease;
- Creating, modifying , or terminating any agreement affecting compensation of an officer or manager of the company;
- Incurring or refinancing debt;
- Mergers and joint ventures;
- Amendments to the Operating Agreement;
- Filing bankruptcy;
- Dissolution or Liquidation of the company;
- Issuing additional units in the company;
- Hiring of family members;
- Changing the nature of the business;
- Purchasing property in excess of a certain amount; and
- Making distributions or payments to owners or employees of the company in excess of a certain amount, or percentage of book value.
Other issues that the Shareholders Agreement addresses include what events trigger rights to a put or call on voting and/or non-voting units. These can include:
- The permanent mental disability of a shareholder;
- The death of a shareholder (the terms can vary depending on whether life insurance was purchased to facilitate a buyout or not;
- Divorce or separation of a shareholder;
- Retirement of a shareholder;
- Involuntary transfers of units; and
- Transfers of units in breach of the Agreement.
Additionally, the Shareholders Agreement may contain provisions known as “Drag Along / Come Along” rights. The former allows the majority holder to force the minority holder(s) to agree to a sale even if they do not wish to sell. While the latter allows a minority holder who does want to sell to benefit from the same terms that the majority holder has agreed to, even if the buyer is otherwise uninterested in purchasing the minority interest.
The Shareholders Agreement is important due to the wide variety of issues it addresses and because it has the ability to act as a referee among the family members. Thus, no one family member has to “be the bad cop;” the rules are simply the rules and the whole family must follow and respect them. In addition to creating the Shareholders Agreement, it is often advisable for the Founder of the business to begin transitioning control and/or decision making authority away from themselves while they are still alive. This method will allow the people succeeding to control of the company to have a safety net, as well as to allow suppliers, contractors, employees, and clients to get to know the new players in the game. The ultimate goal is for a seamless transition of the Family Business upon the death of the Founder and for its continued success thereafter.
How the SEC Lifting the Ban on General Solicitation for Certain Private Offerings Opens up Additional Source of Capital for Small Businesses
Small businesses in recent years have been dealing with very tight lending markets that have affected their ability to grow or in the case of startup businesses develop at all. Another alternative to bank financing for these small businesses is raising capital through a private investment offering. However, until recently this may have been a difficult process for small businesses because of the ban on being able to solicit and advertise a private investment offering which left the small business owner only able to look for capital from their family and friends. Congress recognized the issues small businesses were facing with regard to raising capital and in April of 2012 passed the Jumpstart Our Business Startups Act (the “JOBS Act”). The JOBS Act directed the SEC to amend its rules within 90 days of the act to remove the prohibition on general solicitation and general advertising in securities offerings conducted pursuant to rule 506. These rules were finalized in July 2013. The newly adopted rule adds a new and separate exemption, Rule 506(c), which is available to an issuer that wants to use general solicitation and advertising to offer securities that are ultimately sold to accredited investors. For individuals, accredited investors are defined as persons whose net worth exceeds $1,000,000 (not including any equity in the individual’s primary residence) or whose income exceeds $200,000 per year (or $300,000 for joint income with spouse) in each of the past two (2) years. The newly adopted rules do require that an issuer take “reasonable steps” to verify that a purchaser of its securities is an accredited investor. Reasonable steps would include reviewing financial statements and tax returns of the investor to confirm accredited investor status. If an issuer chooses to use the Rule 506(c) exemption no non-accredited investors could invest in the offering.
Rule 506(c) presents a new offering exemption but it is important to note that the current 506 offering exemption remains in place. Therefore, if an issuer does not need to generally solicit and advertise the issuer can sell to an unlimited number of accredited investors without the “reasonable steps” verification process and up to 35 non-accredited investors.
If you are a small business in need of capital or an entrepreneur looking for capital to start a new business please contact us to explore the possibilities of raising capital using this new private offering exemption or under the current 506 offering exemption. Given the newness of the JOBS Act and the new 506(c) offering exemption there will be continuing amendments made to the rules so it is very important to discuss the possibility of any offering with a qualified securities attorney.
1. I’ve heard of a living trust and heard that it avoids probate. What is probate and how does a living trust “avoid” it?
Probate is a court proceeding. In Florida, it can be time consuming and costly. Much of it is also public. Consider the case of Joe and Mary. They had run their own hardware store for many years. Joe owned half the stock in their family store and Mary owned the other half. They owned a home jointly. Mary had also inherited some money which she invested in rental property. Their savings was in a bank account, which they had decided to put in Joe’s name.
When Joe died, Mary learned that she didn’t yet own all the company. Joe’s stock had to be probated before it could be put in her name. Then she learned that she couldn’t get access to the savings. The court had to appoint her personal representative of Joe’s will before she could draw on any of those funds.
When the business creditors found out about Joe’s death, they waited until the will was filed for probate and read it. They saw that the will left everything to Mary, but they weren’t sure she was going to keep the store open, so they began calling her for answers. Joe had been prominent and, to Mary’s dismay, she learned that much of the probate proceeding was public record.
Over a year passed and Mary eventually settled the probate estate. She then heard of a living trust and heard that it avoids probate. She learned that during her lifetime, she would be in complete control of her living trust. She could buy and sell assets in the trust, even run the business, as easily as if she owned those assets herself. At her death, one of her children could succeed her as the trustee of the trust and its assets would pass then free from probate. Mary established a living trust, placed the company stock and her other major assets in the trust, and things ran smoothly for her after that.
2. If everything I own is in joint names, won’t that avoid probate, too?
Yes, but there are some things to add here. First, if you own an asset with your spouse, it will go through probate at your spouse’s later death. Second, consider what may happen if you should put a child’s name on that asset. Mary did so after Joe’s death, and added their son, Sam, as a joint owner of the savings account. Sam had started his own hardware business in a neighboring town, but he didn’t have quite his parents’ talents or experience. When the business started to fail, his creditors were able to reach the savings account he held with his mother and nearly wiped it clean. So while joint ownership is a shortcut to avoid probate, it can create some very special problems of its own. For these reasons, a living trust is a preferable way to avoid probate.
3. My bank told me to just use a “Pay on Death” account to name my heirs. Does that avoid probate?
Yes, it can. But it can raise questions, too. After her husband’s death, Mary decided to set up a POD account so that her grandchildren, Sam’s kids, “would also get something.” She set up another savings account and added her grandchildren, as a “Pay on Death” beneficiaries. At her death, she thought that the account would automatically pass to her grandchildren. She also thought that this was enough to protect the account from any claim or control by Sam’s wife, Christine. Mary had always mistrusted Christine and they had never gotten along.
When Mary passed away, the grandchildren were still very young. Christine made claim to the account on behalf of her young children and was able to get control of the funds at that time. Mary’s desires were thwarted.
This result could have been avoided if Mary had used a living trust instead of the “Pay on Death” shortcut to avoid probate. The living trust could have properly excluded Christine from control of the grandchildren’s funds at Mary’s death.
4. My life insurance agent told me not to worry about probate of my life insurance because insurance does not go through probate. How does this work?
That’s correct (provided it is not payable to your estate). Sometimes, though, you may not want your beneficiaries to receive such a large sum of cash right away. Many couples want their young children to be protected and set up trusts for them in their estate planning. The trusts postpone the children’s receipt of money until they are more financially mature and keep those funds safe for college expenses or emergencies. If a couple were to simply name their children as the beneficiaries then the children would get the proceeds right away with no strings attached. So further planning can be helpful in order to coordinate the beneficiary designations with the parents’ overall desires.
5. What about my home?
In Florida, there are very special considerations that apply to your home. First, it can be eligible for homestead tax exemptions. Second, it can be protected from your creditors. Third, Florida law restricts the ways that you can pass your home at your death. That law originally designed to protect widows and orphans, can lead to some unintended consequences, especially if you have remarried and have a minor child by your first marriage. Each one of these features needs to be taken into account when planning your estate.
6. How does a living trust avoid guardianship?
One of the most helpful features of a living trust is that it can serve as a way for your family to manage your assets if you should become disabled. Often, an adult child is named the successor trustee of a living trust. If you are disabled, that son or daughter, as successor trustee, can have access to the accounts in the trust and must use those accounts for your care. Bill paying and management of your assets is done through your trust and a costly guardianship proceeding can be avoided.
7. Won’t a durable power of attorney do the same thing?
A durable power of attorney is only a start. Because many financial institutions require their own form of power of attorney, it is often difficult to get a financial institution to honor a blanket durable power of attorney not pre-approved by them. This can cause delays when your power holder needs to get to your accounts to pay your bills. A living trust avoids this delay. It is an instrument which has been universally respected by such institutions for some time.
It should be noted here, too, that a fairly recent change to Florida law has required that many older Durable Powers of Attorney must be updated. If you have a Durable Power of Attorney, you should check its date. If you had it drawn up before 2012, it would be a good idea to call your attorney to determine whether it should be updated to reflect current law requirements.
6. What’s the takeaway?
Use of a living trust is much more effective way to put in place your desires for your heirs. A properly funded living trust avoids probate and avoids guardianship. In the long run, it can save your heirs time and money. That’s the good news in using a living trust as the foundation of your estate plan.
The article is co-authored with Estate Planning & Probate attorney Paige Hammond Wolpert.
What is Probate?
Probate is a court supervised process whereby the validity of a decedent’s Last Will and Testament is proven, a legal representative is appointed to the administer the estate (in Florida this person is referred to as a “Personal Representative”), and the estate is settled so that valid creditors are paid and beneficiaries receive distributions of the decedent’s property to which they are entitled. If the decedent dies without a Last Will, also referred to as dying intestate, a similar process is followed. However, the individuals who receive the decedent’s property (referred to as “heirs”) are determined by the Florida law.
Are There Different Types of Probate?
There are two types of probate administrations. The amount and nature of the assets owned by the decedent dictate which type is appropriate. Chapter 733 of the Florida Statutes provides the framework for the administration.
Formal Administration. If the decedent owned assets in his or her sole name in excess of $75,000 (not including the decedent’s homestead property), a formal administration is usually required. A formal administration involves filing an initial Petition for Administration with the probate court identifying the decedent, listing the decedent’s assets, and requesting that a personal representative be appointed to administer the estate. Notice of the proceedings must be given to the decedent’s beneficiaries and to the decedent’s creditors and an inventory of the estate must be filed with the probate court. A formal administration typically takes from 6 to 12 months to complete. However, formal administrations that involve more complex issues such as the probate of real estate, tax issues, or litigation, may continue for a much longer period of time. Under Florida law, a Personal Representative must be represented by legal counsel throughout the formal administration.
Summary Administration. For a decedent with assets in his or her sole name worth less than $75,000 (not including the decedent’s homestead), a less extensive administration, referred to a summary administration, may be appropriate. A summary administration may also be used if the decedent owned only homestead property at this time of his or her death. A Petition for Summary Administration, along with a proposed order specifying who is to receive estate assets and which creditors should be paid and in what amount, is submitted to the probate court. Once the order is entered, the summary administration is complete. Some courts also require that a notice to estate creditors be published in a newspaper within the summary administration. Summary administrations can typically be completed in a matter of months depending upon the probate court’s caseload.
What does NOT trigger the need for Probate?
Control and Disposition of the Decedent’s Remains. Unless the decedent’s Last Will and Testament provides to the contrary, a surviving spouse or next of kin (such as the decedent’s children) can legally control the disposition of the decedent’s remains without initiating a probate proceeding. If the surviving spouse and next of kin are in disagreement as to the disposal, Section 497.005(39), Florida Statutes, provides that the surviving spouse has the ultimate decisions making authority regarding the remains unless the surviving spouse has been arrested for committing an act of domestic violence against the decedent that resulted in or contributed to the death.
Disposition Without Administration. For smaller estates, no administration may be required at all. For example, if the decedent owned only certain exempt property and nonexempt personal property not exceeding the sum of the amount of funeral expenses and the decedent’s reasonable and necessary medical and hospital expenses of the last 60 days of the last illness, then a disposition without administration may be appropriate. Pursuant to Section 735.301, Florida Statutes, the decedent’s property may be transferred if an interested party sends an affidavit or letter to the court requesting the payment or transfer of the decedent’s property to persons entitled to that property. Once the court receives the informal request, the court may authorize the payment, transfer, or disposition of the decedent’s personal property in writing without the need for a formal administration.
Decedent Owned Automobile in Sole Name. If the decedent owned an automobile in his or her sole name, that automobile transfers automatically as an operation of law pursuant to Section 319.28, Florida Statutes, without a probate. If the decedent had a Last Will, the Will should be presented, along with a death certificate and an affidavit that the estate has sufficient assets to pay creditors or that it is not indebted, to the Department of Motor Vehicles to show who has the legal right to take title to the automobile. If the decedent died intestate, an affidavit stating that the estate is not indebted and that the surviving spouse (if any) and heirs of the estate have agreed who should take title to the automobile is submitted to the Department to transfer the title.
Jointly Owned Property. If the decedent owned a parcel of real estate as a joint tenant with rights of survivorship, the parcel will pass automatically to the surviving owner or owners when the decedent dies. No administration of the real property is required. There is also no need to do a new deed for the real property. A death certificate without the cause of death will need to be recorded in the public records in the county where the real property is located. Generally, no probate administration is required for other types of property owned jointly by the decedent and another party, including bank accounts, investment accounts, and automobiles. A determination must be made as to whether such accounts were owned by the parties with survivorship rights or whether a party was placed on the account simply for convenience, without survivorship rights. Under Florida law, there is a presumption that the decedent intended for any joint assets to pass to the surviving joint account holder unless the presumption is rebutted in the decedent’s Last Will and Testament.
Tax Refund. If the decedent is entitled to a tax refund from the Internal Revenue Service not in excess of $2,500, Section 735.302, Florida Statutes, states that the refund may be paid directly to the decedent’s surviving spouse, or if there is no spouse, to his or her surviving children over the age of 14.
Assets Payable to a Named Beneficiary. Assets that are payable to a named beneficiary such as life insurance policies, retirement accounts, and some bank and investment accounts, pass directly to the named beneficiary and need not be probated. These would include POD (payable on death) accounts, TOD (transfer on death) accounts, and ITF (in trust for) accounts.
Veterans’ Survivor Benefits. Most benefits payable to the survivors of a decedent are paid directly to those survivors and are not probated. Information regarding veterans’ benefits can be obtained from the United States Department of Veterans Affairs, Benefits Information and Assistance Office.
Social Security Benefits and Claims. Social security benefits are payable directly to the decedent’s spouse or dependent. Information on these benefits can be obtained from the Social Security Administration, which publishes a Social Security Handbook that details the programs available to survivors.