It is happening with more and more frequency…someone knocks on the door and announces him or her self as the child of the man answering the door.  DNA and the rise of Ancestry.com and the like have created this potentially awkward moment over and over again.   In many cases it is a beautiful moment.  I have read cases, where strong bonds have been formed between the man and the child.  I have even read about cases, where the mother and the man have married or are living together.  But what are the legal ramifications to the donor.  Typically, he went to a sperm bank or infertility clinic, and didn’t want to be found out.

State law on the issue varies.  About two-thirds of states (including Texas) have adopted the Uniform Parentage Act (UPA). The UPA establishes that any male who provides sperm under the guidance of a physician for purposes of artificial insemination is not the father unless he is legally married to the recipient. Therefore, if there is no legal marriage, the male who provided the sperm is not legally obligated to perform fatherly duties such as paying child support. However, most states adopting the UPA have not been willing to extend protection to the donor in cases where the insemination process does not involve a physician.

In many cases, the donor is known, and in those cases, an agreement should be put in place so the parties intentions are clear.  Without an agreement (and perhaps even with one if the donor become active in the child’s life) a court will typically rule based on the best interest of the child, and that could mean child support payments.

I have been involved in many premarital agreement situations where the parties got upset and decided the negotiations were hurting their relationship, so they decide to drop it.  In Texas, there is an option, however, for the person of means to pursue that can be done without the knowledge or consent of their fiancee.

The moneyed fiancee can create a limited partnership and contribute the assets he or she wants protected to it.  This should maintain the separate property character of the assets contributed to the partnership during the marriage as long as the assets remain in the partnership.  Distributions from the partnership are thought to be community property, and the moneyed finacee should be aware that some assets, such as royalty payments, are separate property and contributing them to the partnership could convert those payments to community property.

The moneyed finacee also should be aware of the Jensen rule, and pay him or herself reasonable compensation for his labor and services rendered to the partnership to avoid a claim for community reimbursement.

While not as effective as a well-drafted premarital agreement, the use of a  limited partnership offers the moneyed finacee a way to provide significant protection if things don’t work out for better or worse.

March of Dimes was created to deal with polio, and was left without a mission once a vaccine was developed.  So with a nationwide infrastructure in place, it decided to change its mission from polio to premature children.  Today, if a 501(c)(3) wants to broaden or change its mission it doesn’t need to file a new 1023 and seek a new determination letter.  Instead, all it needs to do was notify the IRS on its annual 990.  On the state level, it will need to amend its Articles of Formation to reflect the new purposes of the organization.

Use of donated funds is a bit more complicated.  If funds already raised are restricted, it will not be able to use those funds for the new charitable purpose.  It would be better to raise new donations for the new purpose and segregate them from existing funds.

The bottom line is a charity can change and evolve.  It doesn’t have to start over.

Recently, the Alaska Supreme Court in Toni 1 v. Wacker put a nail in the coffin of domestic asset protection trusts as effective creditor protection for out of state donors.   After a Montana state court issued a series of judgments against Donald Tangwall and his family, the family members transferred two pieces of property to the “Toni 1 Trust,” a trust allegedly created under Alaska law. A Montana state court and an Alaska bankruptcy court found that the transfers were made to avoid the judgments and were therefore fraudulent. Tangwall, the trustee of the Trust, then filed suit, arguing that Alaska state courts have exclusive jurisdiction over such fraudulent transfer actions under AS 34.40.110(k). The Alaska Supreme Court concluded this statute could not unilaterally deprive other state and federal courts of jurisdiction, therefore it affirmed dismissal of Tangwall’s complaint.

Planners have long wondered if the full faith and credit clause of the US Constitution would prevail over state laws in DAPT states.  The answer is “yes” in Alaska.  It likely is “yes” anywhere else in the United States.

You can still do a DAPT for estate planning reasons, and they do provide asset protection as a trust in the state of the donor’s residence would.  You just can’t avoid a judgement in the donor’s state of residence by fraudulently transferring assets to a DAPT created in another state.

You can still create a foreign trust which isn’t subject to the constrains of the US Constitution, but foreign trusts raise another set of issues.

When in comes to asset protection planning, do it when the skies are clear and have other reasons for doing it.

Proposed regulations were issued in November under Code Section 2010 addressing the possibility of “clawback” when the temporary high exemption amount reverts to pre TCJA levels (adjusted for inflation).  The good news is that the proposed regulations state that clawback will not occur if one fully uses his or her exemption amount prior to sunset.  The bad news is that the proposed regulations did not address the issue of what happens if you only gift the temporary exemption increase during the period when the temporary high exemption is in effect.

The consensus at Heckerling was that if you only gift the exemption increase you will not have any remaining exemption left after sunset, other than annual increases for inflation.  So it is “use it or lose it.”

Here in Texas and other community property states, we can offer you ways to fully utilize the temporary high exemption amount without losing income on gifted assets and obtain some asset protection in the process.   The time to act is now, however, since it is very possible that the current political environment could result in a termination of the temporary high exemption amount as early as 2021.

In theory conservation easements are simple- a landowner grants a perpetual easement on a portion of his land for a charitable purpose and gets an income tax deduction for the reduction in value to the land encumbered by the easement.   Many wealthy landowners have successfully done conservation easements.  However, they have been highly abused over the years with inflated appraisals and syndication of the concept.

Recently, the Tax Court in Pine Mountain Preserve channeled Meatloaf’s famous song, and held that two out of the three conservation easements claimed were bad.  The issue here wasn’t inflated appraisals but rather improper reservations of future residential development of sixteen homes on the easement property without specifying where this potential residential development could be done.  This meant that the easement was not granted “in perpetuity” as required by Section 170(h)(2)(C) the Internal Revenue Code.

Bottom line is this- if you are going to consider a conservation easement, apply the KISS principle.  The statute is straightforward, keep the deal simple and get a highly qualified appraiser that follows best practices.

Proposed regulations on Qualified Opportunity Funds (QOF) were released at the end of October.  The regulations are complex, and a complete analysis is beyond the scope of a blog post.  However, there are some interesting provisions to note:

  1.  There was some confusion over whether the deferred gain had to be recognized 12/31/2026 if the property is not sold.  The answer is “yes.”
  2. Investment in a QOF can be directly in a Qualified Business Zone Property (QBZP) or indirectly in a corporation or flow through entity.  The rules are different for each.  Most interestingly, indirect investment cannot be in a so-called “sin business” such as golf course (I didn’t know golf was a sin), massage parlors, hot tubs, sun tanning and gambling, but the sin business prohibition does not apply to direct investment in a QBZP.
  3. If a QOF sells its interest in a QBZ, it can elect to defer again if the sales proceeds are reinvested in another QOF within 180 days.
  4. If you own a QOF via a partnership interest (or other flow through entity) and the partnership elects not to defer capital gain, you can elect to defer your distributive share of the capital gain by investing in another QOF within 180 days.

Comments are being submitted on these proposed regs.  We will continue to monitor this new investment opportunity.

S corporations are pass through entities, but lack the flexibility of partnerships.  When more than 20% of the stock of an S corporation is sold, the issue arises as to how to account for income to the shareholders during the year.  The default rule is to wait until the the end of the year, determine income for the year and then allocate it on a per day basis.  For example, if shareholder A owns 50% of the S corporation and sells all of his stock on October 1 to shareholder B and the S corporation has $100 of income, shareholder A will be allocated $75 of income.   But what if all $100 of income is earned after October 1?  Poor shareholder A will be allocated $75 of income, but will have no right to receive any of it since he wasn’t a shareholder when it was earned.  This creates a phantom income problem for shareholder A.

What is the solution for shareholder A?  Well if all shareholders agree the S corporation can elect to use the cut off method.  The cut off method creates two separate tax years-one to the date of sale and one after.   The cut off method can be elected anytime before the tax return is filed. However, there will usually be a winner and a loser here.  In this case shareholder B would be disadvantaged to agree to the cut off method.  Therefore, it is recommended that shareholder A require the cut off method to mandated in the stock purchase agreement.

The common wisdom is to select an LLC for a new business.  That wisdom needs to be scrutinized.  Sure forming an LLC is easy.  Generally, the filing fees are less than a corporation, and the documentation is less complicated.

While the LLC may remain the best choice for an investment, it can create issues for an operating business.  With the corporate tax rate now only 21%, the tax advantages of an LLC have diminished.  Yes, in early years the LLC is likely to generate losses, which can flow through to the owners but this flow through status can cause headaches down the road.   For example,  employees in corporations are often given stock options.  In an LLC employees might be given “profits interests,” which means they start to participate when the founding owners are paid back. The problem is that the profits interest will have to be valued upon receipt.  Intangibles, etc… are hard to value. The LLC may not have the resources to provide a professional appraisal or they may not even be aware of the issue.   If the LLC become valuable, the IRS will have to benefit of hindsight in valuing the profits interest and the employees may have no evidence to counter the IRS with.  The result could be a huge tax surprise for the employees.  In addition, the IRS treats all of the owners as partners, which means they will receive a K-1 from the LLC, which will disclose financial information about the LLC.  Also, each owner is responsible for their own tax withholding payments.

Finally, as a general rule, private equity and venture capital prefers to invest in corporations rather than pass-through structures.  This is because those entities are typically flow through entities and they don’t want the income or loss of their investments to flow through to their limited partners.  This might require their limited partners to pay tax on the income and file a return.  Filing a return creates an additional audit risk they would prefer to avoid.

Again, the type of business will have a significant influence on the legal structure.  Just keep in mind it isn’t as easy as LLC.

Contained in the TCJA, qualified opportunity zones are a new tax incentivized investment vehicle aimed at encouraging investment in low-income housing.  Here are the highlights:

  1.  If a taxpayer has a realized capital gain, taxpayer can invest the gain in a Qualified Opportunity Fund within 180 days and defer the capital gain.  A Qualified Opportunity Fund is an investment vehicle that holds at least 90% of its assets in Qualified Opportunity Zone Property.
  2. A Qualified Opportunity Zone is a low-income community designated as a Qualified Opportunity Zone.  Governors of the states nominate properties, and those nominations are submitted to the Department of Treasury for certification.
  3. An investment in a Qualified Opportunity Zone can be made in a domestic corporation, partnership or a Qualified Opportunity Business Zone Property.  Regardless of the type of investment vehicle, it must be a Qualified Opportunity Business Zone Business.   A Qualified Opportunity Zone Business is a trade or business that owns or leases substantially all of its tangible property in Qualified Opportunity  Business Zone Property.  Among other requirements, the business must generate at least 50% of its total gross income from active business conduct, and alas there is a long list of excluded businesses, including golf courses. Qualified Opportunity Business Zone Property must be acquired after December 31, 2017 and can be new or “substantially improved.”  To be “substantially improved” the taxpayer must invest in the property an amount that exceeds taxpayers adjusted basis in the property over the 30 month period  beginning with acquisition.

The tax benefits of investing in a Qualified Opportunity Fund increase with the holding period.  If the investment is held for 5 years, the taxpayer receives a 10% increase in basis.  If the taxpayer holds for at least 7 years, taxpayer receives an additional 5% basis increase.  All Qualified Opportunity Fund interests held on December 31, 2026 are taxed.   If the Fund continues to be held after December 31, 2026 and the total holding period reaches 10 years, the taxpayer receives a basis step up to the fair market value at that time.  Accordingly, all appreciation after December 31, 2026 avoids tax.

Regulations on Qualified Opportunity Funds were recently issued, and we are studying them.  Let us know if we can assist if you are considering investing in this interesting new investment vehicle.