Clients frequently seek legal advice when they are considering the start-up of a new venture or investing in an existing business. Challenging aspects of these deals include the tax issues that arise by virtue of different investors contributing different mixes of resources to the venture.

Consider that some clients are the idea people who hold a patent or copyright or perhaps just have an idea in the conceptual stage. Others will provide tangible capital needed for the new business in the form of cash, real estate, equipment, etc. Others may contribute knowledge or other assets, such as a customer base, industry know-how and experience, a great “Rolodex” of contacts, or even an existing business with goodwill value. Then there are the service providers–those who contribute no property or capital but who will bring the “sweat equity” needed to convert tangible and intangible property into profits.

All of these clients could incur tax burdens differently, depending somewhat on the form of entity being created in order to conduct the venture. Selections include different types of corporations, limited liability companies, limited partnerships, or perhaps no entity at all in certain situations. In planning the formation of the entity, each participant must be careful not to trigger immediate income tax liabilities when contributing the property or services.

Federal tax law contains many intricate and detailed provisions governing the tax treatment of receiving an ownership interest in a new venture. The rules differ somewhat depending on whether the venture is in the form of a corporation or an entity taxed as a partnership (which includes limited liability companies). However, certain general principles apply to both.

For example, if an investor is awarded an ownership interest by contributing only services to the venture (whether the services were already performed or are to be performed in the future), that person will probably have to include the value of the ownership interest in taxable income. This is rarely a desired result. This treatment differs dramatically from that of a person who contributes property to the venture, whether that property is tangible (real estate, equipment, cash) or intangible (intellectual property, patents, copyrights). Generally a contribution of property to a new venture, in exchange for an ownership interest, is a non-taxable event.

There are, of course, exceptions to these general rules, including a couple of common techniques for the “service partner” to avoid suffering immediate taxation on the receipt of the ownership interest. One way is to subject the ownership interest to a “substantial risk of forfeiture.” For example, the shareholder or partner in the venture may have to wait for a period of years until free control of the interest is granted. The ownership interest might be contingent on continued employment or the venture achieving certain profitability goals. If the contingencies are not met, the ownership interest might be subject to partial or total forfeiture. Until that restriction is lifted, the holder of the interest is not taxed on the value of the interest.

Another method to avoid immediate taxation applies to members of LLCs and partners of partnerships. The owner could receive a “profits interest” in the venture, rather than a full ownership interest. Immediate income taxation is avoided when receiving a profits-only interest. However, there is a trade-off in that the holder of the profits interest will not fully participate in distributions upon a capital event such as the complete sale of the business or liquidation of the venture.

Even further complications must be addressed when a restricted ownership interest is granted to a participant in the joint venture that is taxed as a flow-through entity (such as an S corporation or a partnership). During the restriction period, there is an issue of who is allocated income on the IRS Form K-1 from the venture. A recent U.S. Tax Court case addressed this issue where an individual executive received a 2% interest in a joint venture, conditioned on continued employment in the venture. The tax advisors of the venture prepared the partnership tax return for the first two years and issued a Form K-1 to the executive, causing him to pay personal income tax on 2% of the profits of the venture. He later contested this result, arguing that as a restricted owner he should not be allocated any profits during that period. The Tax Court agreed with the executive and concluded that, under federal tax law, he was not to be treated as a partner of the partnership for income tax purposes during the period when he could forfeit the ownership interest.

This discussion touches the surface of the types of tax issues that participants will face in the formation stage of a joint venture. There are more in-depth issues that will need analysis to ensure that each participant does not receive an unpleasant surprise when it comes time to report the tax results of the business ownership.

The year 2012 presents U.S. taxpayers with a gift planning dilemma. As the law stands today, and at least until December 31, 2012, every person may transfer up to $5,120,000 (“Estate Tax Exemption”) of assets to any one or more persons (excluding spouses) without incurring estate or gift tax obligations. For a married couple, that amount doubles, up to $10,240,000. This is in addition to the $13,000 that each person can gift annually to as many individuals as he or she desires ($26,000 for a married couple). The Estate Tax Exemption is reduced dollar for dollar for any annual gifts in excess of $13,000 ($26,000 for a married couple).

In addition, transfers to grandchildren and younger generations in trust are subject to a second layer of tax at the grandchild’s death, known as the generation-skipping tax. The generation-skipping tax system also exempts up to $5,120,000 of assets per transferor (also reduced for prior gifts exceeding $13,000 per year, per person to those who are in the grandchildren’s generation or younger).

President Obama’s proposed budget would reduce these amounts to $3.5 million ($7 million per couple). In addition, his budget would make dramatic changes to the use of unique planning opportunities offered by grantor trusts and grantor retained annuity trusts. It is highly likely that nothing will change before the November elections. After that, anything may happen – including nothing – which would take us back to the law as it was in 2001. This would reduce the $5,120,000 exemption to $1 million (with indexing, this is about $1,130,000). We have also been advised that even if these exemptions are reduced in 2013, taxpayers who take advantage of the higher exemption amount now will retain the full benefit of the current exemption, notwithstanding the fact that there may be a lower exemption at the time of their deaths.

For this reason, there is already a flurry of activity in the estate planning area for clients with significant wealth. Many are making outright gifts of significant amounts to children and grandchildren. Some are doing so using irrevocable trusts, in order to regulate distribution and protect trust assets from dissipation caused by divorce and creditor claims. People are living longer and the prospect of second marriages raises concerns for the senior generation. Trusts provide the grantor with the ability to preserve family wealth for the grantor’s bloodline.

Still others are employing leveraging transactions such as grantor trusts or grantor retained annuity trusts, which are specially crafted trusts that effectively increase lifetime gifting. Family limited liability companies continue to serve as valuable planning vehicles for both wealth transfer and asset protection. There are any number of powerful estate planning techniques that can be used to take advantage of the increased exemption in the most tax-efficient manner.

What if you cannot afford, though, to give up control of the wealth you transfer, but wish to lock in the $5,120,000 exemption? If you are married, one possibility is for each spouse to set up different trusts so that the other spouse has use of the gift during his or her lifetime and that, upon death, the property goes to the lineal descendants. If both spouses live to their “life expectancy” ages, the income and principal of the trust, within limits, will be fully available to the spouses making the transfer, for most of the rest of their lives. At the same time, the full exemption is used and the transfer could be exempt from estate taxation forever. Here is an example:

Rick and Leslie are married. Rick’s net worth is $20 million, consisting almost entirely of the value of the family business owned by Rick. Leslie’s net worth is $10 million, which includes the principal residence, a second home in California, about $4 million of investable assets and about $4 million of stock in the family business. Rick and Leslie expect their estates to pay an estate tax, at the death of the survivor, of at least $10 million. They want to take advantage of the current $5,120,000 per person exemption in 2012 and also remove appreciation in assets from their estates.

In February 2012, Rick established an irrevocable grantor trust. It provides that Leslie gets all of the income and principal, as needed, to support her lifestyle. Rick transferred his non-voting shares of the family business to the trust with a value of $5,120,000. A bank was selected as trustee.

In May 2012, Leslie decided to do something similar to Rick, except that her trust may, at the discretion of the trustee, accumulate income. In addition, the principal may be distributed to Rick, again at the discretion of the trustee, and his will contains a power of appointment which enables him to affect the relative ownership of shares of the trust by the next generation. One of Leslie’s trusted friends is the trustee.

Until the death of either Rick or Leslie, they will have the full benefit of the income and, potentially, the principal as needed from both trusts. When one dies, the survivor must be able to live without the income from 1/2 of the property, although life insurance can be purchased to protect against a premature death. In the alternative, certain limited powers of appointment may be used to prevent the loss of income on the first death.

There are also many other leveraged ways to take advantage of the current law. Do not be lulled into a false sense of security based upon the current $5,120,000 exemption. As noted above, we do not know what Congress will do, and there is a possibility that the exemption may revert to $1,130,000. Although no one can tell what will happen in the future, there are ways to lock in today’s law without giving up full control over the property you gift. For more information, please contact any of our Tax and Wealth Management Attorneys: