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Legal Alert

September/October 2004

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In this issue . . .

• FLPs get new life as estate planning tools
• Former addict denied rehiring to have his day in court
• Will you play a role after you sell your business?
• New option for employee health care coverage: HSAs
• HIPAA and Privacy

FLPs get new life as estate planning tools

Many taxpayers use family limited partnerships (FLPs) to limit tax liability when transferring assets to the next generation. FLPs allow them to retain some control over their assets during their lifetimes.

But the IRS has increasingly challenged FLPs, arguing that assets transferred to an FLP should be included in the transferor’s taxable gross estate at death. Nevertheless, a recent Tax Court decision shows that properly planned FLPs can survive IRS attack.

The code’s exception

Internal Revenue Code Section 2036(a) requires decedents’ taxable gross estates to include the value of all property they transferred during their lifetimes while retaining:

1. Possession or enjoyment of or the right to income from the property, or
2. The right, either alone or with any other person, to designate the persons who shall possess or enjoy the property or its income.

The statute is intended to ensure that a decedent’s gross estate includes transfers that are essentially testamentary, that is, transfers of assets that the decedent continues to hold significant interest in or control over.

But an exception comes into play if an estate can show that a decedent either: 1) transferred assets in a bona fide sale for adequate and full consideration in money or money’s worth, or 2) didn’t retain possession or enjoyment of or the right to income from the transferred assets.

The IRS wins one

The IRS often challenges FLPs by asserting a decedent retained possession or enjoyment of FLP assets or the right to income through an implicit understanding. The IRS claims this understanding can be inferred from the facts and circumstances surrounding a transfer and later asset use.

In a widely discussed case, Estate of Albert Strangi v. Commissioner (Strangi II), the Tax Court listed several facts and circumstances that support a finding of an implicit understanding:

• Transfer of most of a decedent’s assets,
• Decedent’s continued use or occupation of transferred property,
• Commingling of personal and FLP assets,
• Disproportionate FLP distributions,
• Payment of personal expenses with FLP funds, and
• A transfer’s testamentary characteristics.

So the court held that the property transferred to the FLP in Strangi II was includable in the decedent’s estate and thus was taxable.

The IRS loses one

After Strangi II, many estate planners became concerned about the future of FLPs. But another case, Estate of Eugene E. Stone, III v. Commissioner, shows how taxpayers can prevail against the IRS.

In Stone, the decedent formed FLPs with each of his five children. He gave each a small general-partner interest in his or her respective FLP in exchange for their contributions at formation. The decedent held most of the general- and limited-partner interests in the FLPs. He and his wife contributed most of their assets to the FLPs — including stock in the family business — but retained sufficient assets to maintain their lifestyle. When the decedent died, four of the FLPs made non-pro-rata distributions to his estate to pay the estate tax.

The IRS contended that the transfers didn’t constitute bona fide sales that qualified for the exception to Section 2036(a). Unpersuaded, the Tax Court cited several factors that indicated a sale:

• Each family member retained independent counsel and had a say in structuring and operating the FLPs and the assets to be transferred to each.
• The parents ultimately decided which — if any — of their assets to transfer.
• The parents didn’t transfer all their assets, but rather retained enough to maintain their accustomed living standards.
• The parents didn’t merely acquiesce to their children’s recommendations about structure, funding and operation. Instead, the decedent’s attorney after consultation drafted the final partnership agreements.
• The decedent did more than just change the form of the contributed assets. The FLPs carried economic substance and were operated as joint for-profit enterprises, with the children actively participating in asset management and development.

The court concluded that the asset transfers to the FLPs represented more than a mere “recycling of value” as in Strangi II and fell within the exception for bona fide sales.

How to win

The Tax Court’s opinion in Strangi II caused much alarm about the continued validity of FLP transfers, but Stone shows that asset transfers to FLPs can survive IRS assault. With proper planning, FLPs can provide tax benefits while minimizing the likelihood of a successful IRS challenge.

Structuring an FLP

The court in Stone offered these insights on how to structure a family limited partnership to avoid the inclusion of transferred assets in a gross estate:

• Establish clear business purposes for the FLP — such as facilitating consolidation of FLP partners’ investment assets for improved management or protecting assets from partners’ creditors’ claims.
• Operate FLPs as joint for-profit enterprises.
• Ensure that assets essential to the FLP’s business are used exclusively for FLP purposes.
• Erect a wall between FLP assets and personal assets by not funding FLPs with personal assets and not commingling FLP funds and partners’ personal funds.
• Retain sufficient funds for FLP founders to maintain their accustomed living standards and to pay anticipated estate tax and costs.
• Bar, if practical, all distributions during an FLP’s term, but at least don’t make disproportionate FLP distributions and particularly avoid basing distributions on the founder’s personal needs.
• Continue to operate the FLP after a founder’s death, investing assets according to the FLP’s existing business objectives.

Former addict denied rehiring to have his day in court

Can employers rely on unwritten policies to protect against claims by workers protected by the Americans with Disabilities Act (ADA)? That was ultimately the question in Hernandez v. Hughes Missile Systems.

Rehiring denied

An employee tested positive for cocaine and was forced to resign for violating workplace-conduct rules. More than two years later, he applied to be rehired to his previous position and attached letters attesting to his recovery. A human-resources employee reviewed and rejected his application.

The ex-employee sued, alleging disparate treatment in violation of the ADA. He argued that the employer rejected his application because of his addiction record, because he was regarded as being a drug addict, or both. The HR employee who reviewed and rejected his application testified that the employer had a policy against rehiring employees who had been discharged for workplace misconduct. And though she had access to his entire personnel file including his drug-test results, she testified that she hadn’t known he was a former drug addict when she rejected his application.

The ex-employee argued that even if the no-rehire policy was neutral, it still violated the ADA because of its disparate impact. That is, the policy fell more harshly on one group of former employees (here, recovered addicts) than another and couldn’t be justified by business necessity. The trial court threw out his disparate-treatment claim without a trial and rejected his disparate-impact claim as untimely filed.

The Ninth Circuit agreed that he had filed his disparate-impact claim too late, but it reinstated his disparate-treatment claim for trial. The court held that the employer hadn’t provided a legitimate nondiscriminatory reason for not rehiring him, because its no-rehire policy — though facially lawful — was unlawful as applied to workers who were lawfully forced to resign for illegal drug use but who had since been rehabilitated.

Supreme Court finds error

The Supreme Court held that the Ninth Circuit erred when it rejected the no-rehire policy because it wrongly combined “the analytical framework for disparate-impact and disparate-treatment cases,” mixing apples with oranges. Had the Ninth Circuit applied the law correctly, it would have been obliged to conclude that a neutral no-rehire policy was — by definition — a legitimate nondiscriminatory reason under the ADA.

Thus, the only remaining analysis was whether a jury could conclude that the stated rejection reason was pretextual, that is, designed to hide the real — and discriminatory — reason. The Supreme Court sent the case back to the Ninth Circuit.

Ninth Circuit decides again

First, the Ninth Circuit noted that the ADA protects persons “who have successfully completed or are participating in a supervised drug-rehabilitation program and are no longer using illegal drugs” and those “who are erroneously regarded as using drugs when in fact they are not.”

The court then noted that the alleged no-rehire policy wasn’t in writing, even though the employer had “an extensive set of written personnel policies covering various subjects, including substance abuse.” The court also noted that the employer hadn’t mentioned the alleged policy until after EEOC conciliation efforts had failed and the employee had sued.

The Ninth Circuit held that a jury could infer that the alleged unwritten policy “either did not exist or was not consistently applied,” because no one at the company could identify its “origin, history, or scope.”

The court concluded that the ex-employee had presented sufficient evidence for a reasonable jury to find that the company had refused to rehire him because of his addiction record. So it sent the case back to the trial court.

Employers must tread wisely

This case shows that employers can’t rely on unwritten policies to protect them from claims by former addicts or others protected by the ADA. Employers must exercise extreme caution in hiring, firing or rehiring these workers, and be sure all policies are in writing.

Will you play a role after you sell your business?

Many business owners discover that a buyer wants them to remain involved with the company for at least some period after the sale. A wise buyer knows that much of a company’s critical knowledge capital is stored in the seller’s head and wants to be able to tap that knowledge at least during the transition. So sellers can choose to continue to play several roles in their businesses after selling them. Let’s take a look at how to plan for these roles.

Employment contracts

A buyer may retain a seller’s involvement in the business through an employment contract. Then the involvement tends to be short-term — even if not initially envisioned that way. One pitfall is that some sellers don’t move easily from running the show to taking direction as an employee. So sellers should separate their employment contracts from purchase contracts to ensure that an employment relationship’s failure doesn’t doom the entire deal.

Employment contracts offer sellers some advantages. One advantage is to allow sellers to continue to receive insurance, expense accounts and other benefits. These perks constitute taxable income for sellers and deductible business expenses for buyers.

But former owners must perform sufficient work to qualify as employees in the IRS’s eyes, especially when a family business is sold to a younger family member. If the IRS finds that a seller’s compensation wasn’t earned, the business can’t deduct it. Conversely, if a seller remains in the same presale role, the IRS may treat the transaction as a sham — with potentially costly penalties.

Consulting contracts

More typically, buyers and sellers enter into consulting contracts. Buyers pay sellers specified sums for a specified time in exchange for sellers making themselves available for consultation during that time. Buyers pay sellers even if not consulted, but sellers must make themselves available. This may possibly crimp their postretirement plans. So some sellers structure consulting contracts to allow them to employ other consultants in their places.

Consulting fees represent taxable income for sellers, and buyers can deduct the fees. Suppose the parties use a consulting arrangement to convey part of the purchase price as deductible consulting fees. To avoid IRS wrath, the parties may, for example, formalize (with the help of a qualified professional) the consulting relationship in writing and ensure payments are commensurate with the seller’s knowledge and experience.

Seller financing

Buyers may seek seller financing if they can’t borrow enough money elsewhere to buy a company. Seller financing offers flexibility in adjusting interest rates, payment schedules and other terms as needed. But sellers should protect themselves by requiring buyers to provide more security than just that represented by the business or to personally guarantee the loan or both.

Planning is key

Sellers can expect buyers to ask for some level of continued participation — if only to ensure that their businesses are indeed going concerns. But by giving some advance thought to various options, sellers can facilitate a more favorable arrangement.

New option for employee health care coverage: HSAs

The Medicare reform package passed last year also included provisions creating Health Savings Accounts (HSAs). Some small businesses already offered their employees the similar Medical Savings Accounts (MSAs) — but many more workers can take advantage of the new HSAs.

By expanding eligibility, HSAs let employers offer their employees greater options for health care coverage and the opportunity to strengthen their future financial security while controlling costs.

The basics

Employers, employees or both can contribute cash to HSAs. The funds accumulate pretax and employees can use them for qualified medical expenses, such as:

• Doctor visits,
• Prescription and over-the-counter drugs,
• Hospital costs,
• Vision and dental exams, and
• Premiums for COBRA, long-term-care insurance and health insurance during unemployment.

Only the self-employed and employees of small businesses could open MSAs. But HSAs are generally available to anyone under age 65 who maintains a qualified high-deductible health insurance policy. Workers apply their HSA funds to their insurance policies’ deductibles and co-payments. The legislation limits workers’ out-of-pocket expenses under the insurance policies to $5,000 for individuals and $10,000 for families.

The advantages

HSAs offer many benefits for both employees and employers, including tax advantages. Employees can deduct their contributions, and employer contributions don’t constitute taxable income subject to employment taxes. Contributions and earnings grow tax free, and withdrawals for qualified medical expenses aren’t taxed. By using tax-free dollars to pay for their medical expenses, workers essentially reduce their medical costs by their tax rates. They can also use their funds for nonqualified health expenses and withdraw them as cash, though withdrawn funds become taxable income and subject to an additional 10% tax penalty.

Beyond the tax implications, employers may find that HSAs cost less than competing managed-care plans. And their costs may go down if employees make more deliberate — and less cavalier — spending decisions because they’re spending their own money rather than their employers’.

HSAs give employees more choices and greater control in managing their health care expenditures. For example, HSAs allow employees to:

• Select their own doctors without network restrictions,
• Invest HSA funds in interest-bearing vehicles such as mutual funds and individual stocks,
• Carry over their funds and accumulate significant funds for postretirement medical expenses, because they own their accounts,
• Roll over their Medical Savings Accounts into their HSAs, and
• Take their HSAs with them when they change employers. These are just a few of the choices available.

The requirements

Employees opting for HSAs must buy health insurance policies with minimum annual deductibles of $1,000 for individuals and $2,000 for families.

They can contribute up to the amount of the annual deductible — $2,600 for individuals and $5,150 for families in 2004.

Employees age 55 to 64 can make catch-up contributions of $500 in 2004. Catch-up contributions increase in $100 increments annually until reaching a maximum $1,000 in 2009.

Employers must carefully abide by comparability rules: They must make comparable contributions for all levels of participating employees. For example, an employer can’t contribute more for a manager than for a clerk.

The implementation

So HSAs can benefit both employers and employees — tax wise, cost wise and choice wise. Although young healthy workers will likely find HSAs most attractive, employers shouldn’t try to influence employees’ decisions. Rather, employers should provide only general education on the options available, including respective pros and cons.

HIPAA and Privacy

One of the major implications of the Health Insurance Portability and Accountability Act of 1996 (HIPAA) is a requirement that the medical community make certain that each and every patient medical record (known in the Act as protected health information) remains private and confidential. The health care community was given until April 14, 2003 to institute internal procedures that would ensure the continued privacy of medical records. It has been over a year since physicians, hospitals and clinics have instituted such internal procedures and we have begun to see additional repercussions of HIPAA; in some instances, it is affecting the ability of agents under Durable Powers of Attorney and Advance Medical Directives to receive information with respect to their principals. In some circumstances, medical care providers are refusing to disseminate medical information to health care agents in fear that such disclosure would lead to violation of federal law and the institution of fines.

The provisions we previously drafted in Durable Powers of Attorney and Advance Medical Directives, which provide that “my agent is authorized to obtain my health information at any time in his/her discretion,” may not be adequate to some medical care providers to release your medical records to your agents. HIPAA contains very specific rules setting forth the circumstances under which an agent may act for another in requesting such person’s medical records. The regulations provide that the person appointed as an agent under a power of attorney must show that his/her relationship extends specifically to making decisions relating to health care and that the medical records are relevant to making such decisions. Although we believe that the language included in our Durable Powers of Attorney and Advance Medical Directives is legally sufficient to allow health care providers to release medical information to third party agents, recent experience has led us to now recommend that clients execute new Durable Powers of Attorney and Advance Medical Directives to include specific references to HIPAA.

Certain of our clients who executed Durable Powers of Attorney many years ago should note that the medical records language is included solely in their Durable Powers of Attorney and that they may not have a separate Health Care Power of Attorney contained within their Advance Medical Directive; it is especially important for these clients to have their Durable Powers of Attorney updated and at the same time, execute a new Advance Medical Directive to include appropriate Health Care Power of Attorney provisions which comply with HIPAA.

The above changes to your Durable Powers of Attorney and Advance Medical Directive should insure that medical providers will release protected health information to your agents when the need arises. Please feel free to contact your attorney to discuss your documents, or you may call our estate planning paralegal, Bobbie Pearson, directly at (301) 634-3111 in order to arrange preparation of updated documents.