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Transferring Your Wealth While IRS-Allowed Discounts Are Still Available

Written by: Steven M. Burke & Linda R. Garey

Co-written by: Charles Evangelakos from Sagemark Private Wealth Services and Christopher Ayer from Ayer & Associates - Ameriprise Financial Services.

Published in Geared Up (Planet Fitness Independent Franchisee Association) (December 2016)

Many Planet Fitness franchise owners may miss out on a valuable opportunity to transfer wealth to family members and future generations and bypass significant estate and generation skipping transfer (GST) tax hits.  This is because one of the most frequently used techniques to transfer franchise wealth and reduce or eliminate estate taxes on the amount transferred may come to an end if recently proposed Treasury regulations are implemented.

The problem

In a previous communication to all Planet Fitness franchise owners, you were informed about the proposed regulations released in August, 2016 under Internal Revenue Code § 2704. The proposed regulations would, among other things:

  • death bed transfers (defined as transfers within three years of death) will have discounts brought back into Grantor’s taxable estate.
  • eliminate valuation discounts for family controlled business entities (i.e., corporations, partnerships and LLCs) for gift, estate and generation skipping transfer (GST) tax purposes.

 

Effective dates of the proposed regulations

We are currently in the 90-day comment period and there is a public hearing scheduled for December 1, 2016.  Technically, the regulations could be finalized by December 31st  but may not be finalized until early next year.

What if you do no estate planning?

If you do no estate planning, then here is what you can expect.  Let’s assume you die in 2016 and at that time, your Planet Fitness interests have a fair market value of $30 million. Of that $30 million, $5.45 million will be free of federal estate tax (the “applicable exclusion amount” for 2016).  For the purpose of this example, we will assume that your Planet Fitness interests will pass to someone other than a spouse (because you can transfer an unlimited amount to a spouse without any federal estate tax at the death of the first spouse.).  The federal estate tax rate in 2016 is 40%.  You would owe federal estate tax on the amount of $30 million minus $5.45 million at that 40% rate, which means your estate would owe $9.8 million dollars to the federal government, and would be obligated to pay this within 9 months of your date of death. Several states impose an additional inheritance and estate tax, often increasing the amount of estate tax that must be paid. That’s a big tax hit.  Many estates will not have the liquidity to pay the estate tax without selling the franchise.    

How estate planning can help and where the valuation discount fits in

Certain estate planning strategies, some of which benefit from the use of valuation discounts, are available to assist Planet Fitness franchise owners avoid or reduce federal (and often state) estate taxes, and in some cases maintain access to the assets as well.  In the example above, the use of these strategies could save potentially $9.8 million in federal estate taxes.

Valuation Discounting

The IRS values property based upon its fair market value.  If you own 100% of your Planet Fitness franchise, then if the franchise is valued at $30 million, at your death your estate would be taxed on the full $30 million in value.  However, if your franchise is structured (now or through planning) so that you own both voting and non-voting shares, there is an opportunity to take advantage of a “valuation discount.”  Here’s how it works:

Assume your 100% ownership interest is structured so that you own 100% of the voting control (e.g., all Class A voting interests), and you own 100% of newly created non-voting interests (e.g., all Class B non-voting interests).  The non-voting shares are not worth the same amount as the voting shares, because they have no control over the company.  These shares have value, but it is a reduced (or discounted) value.  You can transfer these shares, and their value, out of your taxable estate, retaining full operational control over your franchise.

Valuation firms will evaluate the fair market value of your franchise, and then apply a discount for lack of control and a discount for lack of marketability, and determine an appropriate discount to apply to your non-voting shares.  Frequently, your non-voting shares will be discounted in the neighborhood of 25-30%.  That is akin to a sale of 25-30%.

Transferring discounted non-voting shares can significantly reduce your estate taxes

The most common technique to reduce or in some cases to eliminate your federal estate tax is to transfer some of the Planet Fitness assets – usually non-voting interests as described above -- into one (or more) irrevocable trusts that benefit family members. The assets transferred, and future appreciation of those assets, will not be included in your taxable estate. 

Best of all, you (the franchise owner) can leverage this transfer significantly by gifting a portion to an irrevocable trust (using a portion of your federal gift tax exemption) and then selling a larger portion to the trust, in exchange for a promissory note.  This is where the potential loss of valuation discounts impacts the transaction. 

An Example of how it works

John Smith owns Planet Fitness, LLC (as either a single member or multi-member LLC).  If the company only issued voting interests when formed, it is a straightforward process to recapitalize the LLC operating agreement to provide for non-voting interests as well.  It is these non-voting interests that will be central to the estate planning strategies we have used successfully with numerous Planet Fitness clients already this year.

Assume John’s Planet Fitness company is worth $30 million dollars.  He will retain all of his voting interests, and will remain in full control of the company.  But if his interests are structured properly, we can assist him transfer his non-voting interests into one or more irrevocable trusts, removing the value (and the appreciation) from his taxable estate.

If John is conservative, he may decide to transfer only a portion of his non-voting interests.  Let’s say he starts by agreeing to transfer non-voting interests with a fair market value of $13.3 million.  A modest 25% valuation discount would mean that the discounted value of that interest is $10 million (often valuation discounts can be as high as 40%, depending on the circumstances). 

We would then advise John to:

  • Gift $1 million to the new irrevocable trust (in either cash, marketable securities, or by transferring  some of the non-voting interests), and
  • Sell $9-10 million of his discounted non-voting Planet Fitness interests to the trust.

 

John will have transferred $13.3 million of assets into the trust, removing these assets from his taxable estate, using at most $1 million of his federal gift and estate tax exemption.  He can also allocate a GST tax exemption to the gift which means that the amount gifted will pass to future generations without any GST tax (which is currently also at 40%).

That’s not all.  The future appreciation of all the assets in the trust will be removed from his taxable estate, saving him a minimum of 40% on the appreciation.  We call this an “estate freeze” because the amount of federal estate tax is frozen at today’s values, with no federal estate tax imposed on the appreciation.

Meanwhile John receives income from the trust, because the Trustee of the trust will sign a promissory note to finance the sale of the $9-10 million in non-voting interests.

  • The promissory note can be an interest only note, at the current applicable federal rate (AFR), compounding annually, for a specified period of time (up to 30 years). 
  • Each year, John will receive income from the trust – at the October long term AFR compounding annually rate of 1.95%, over a 20 year term, the yearly principal and interest payment to John would be approximately $608,620.

 

At the end of a 20 year period, assuming an annual 5% growth in assets in the trust:

  • Value of the shares in the trust:  $25,746,161
  • Estate Tax Savings in year 20:  $5.898 million (assuming 40% estate tax, after deducting the amount of federal estate and gift exemption that passes free of tax)

 

Types of Trusts that may be utilized

For married owners, it is often beneficial to transfer the assets into a “Spousal Limited Access Trust” (or SLAT).  The beneficiaries of the SLAT will be the spouse of the owner and any children.  So the assets are removed from the owner’s taxable estate, but are still available to be used for the benefit of the owner’s spouse and children.  We refer to the spouse’s interest as a “safety net.” 

For non-married owners, certain “Intentionally Defective Irrevocable Trusts” (IDITs) can be utilized in a similar fashion, benefiting family members, friends, or charities. 

If formed in a state that allows “dynasty trusts”, such as New Hampshire, either of these trusts can last indefinitely, transferring significant wealth to your children and future generations. 

Advantages of transferring non-voting Planet Fitness interests to these trusts:

  • The full value of the assets (not just the discounted value) is transferred out of the owner’s taxable estate;
  • The future appreciation of the trust assets will not be included in the owner’s (or spouse’s, in the case of a SLAT) taxable estates;
  • These trusts can be generation-skipping trusts and GST exemption can be applied to the transfers;
  • In some cases, we are able to structure the trusts to allow trust distributions to an ILIT (irrevocable life insurance trust), preserving additional gift tax exemption;
  • Both SLATs and IDITs can be designed as “Grantor Trusts” so that the owner continues to pay income taxes on the trust income, allowing further reductions in the owner’s taxable estate without use of gift tax exemption; and
  • With a SLAT, the Grantor has indirect access to SLAT assets through distributions to the spouse (a safety net).

 

Asset Protection and State Income/Capital Gains Tax Planning

We have also helped Planet Fitness clients transfer non-voting shares into a New Hampshire Asset Protection Trust (“NH APT”).  Assets held in a NH APT remain in your taxable estate  but provide significant asset protection benefits from creditors with the added advantage of eliminating state income tax and state capital gains tax upon the sale of a franchise.  This is because New Hampshire does not impose income or capital gains taxes on the assets held in a NH APT.  We would be pleased to provide more information about NH APTs as well.

Summary

Planet Fitness franchise owners can save enormous amounts of future federal estate (and possibly also GST) taxes with careful planning.  You can take advantage of an estate freeze, and transfer discounted non-voting interests into trust(s), that benefit your spouse, your kids, and future generations.  You’ll be transferring the assets at today’s discounted value (the freeze) and the full value and all future appreciation will be outside your federal taxable estate.  If you transfer the assets to a SLAT, you have a safety net because your spouse is a beneficiary.  Meanwhile you receive annual income (from the promissory note) which you have full control over – you can feed it back into the business, or use it for any other purpose. 

If you have any questions, please feel free to reach out to any of us.

Steven M. Burke, Esq. CPA, CGMA
McLane Middleton, Professional Association
45 School Street
Boston, MA 02108-3204
(617) 849-9972

www.mclane.com
steve.burke@mclane.com

Linda R. Garey, Esq.
McLane Middleton, Professional Association
900 Elm Street
Manchester, NH 03101
(603) 628-1325

www.mclane.com
linda.garey@mclane.com

Charles Evangelakos, COA
Sagemark Private Wealth Services
125 Summer Street, Suite 1400
Boston, MA 02110
(617) 728-7447
www.sagemarkboston.com
charles.evangelakos@LFG.com

Christopher Ayer, Financial Advisor
Ayer and Associates
Ameriprise Financial Services, Inc.
35 Chestnut Street, Suite 300N
Portsmouth, NH 03801-4064
(603) 430-9080
www.ameripriseadvisors.com/christopher.ayer
christopher.ayer@ampf.com 

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