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Sunday, April 28, 2024
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Case Studies |
Developer Doubles Unitrusts
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Case:
Donald Developer was a creative and entrepreneurial person. His business and personal affairs often made newspaper headlines. Through a stormy and turbulent career, he acquired large parcels of property and developed them with either commercial buildings or residential structures.
Don has two properties that he is considering selling this year. The first property is owned by a single-member LLC with Don as the member. It has been platted into 100 lots. Don decided to sell lots and in a short period of time sold 80 of the 100 lots. Since he and other associates frequently buy and sell real property, another developer offered Don $600,000 for the remaining 20 lots ($30,000 per lot).
Don also has another 80-acre parcel that he has owned for four years. This parcel could potentially be sold for about $2 million.
Question:
Should Don transfer any or all of these properties into one or more unitrusts? What would his savings be? How could the transactions be structured?
Solution:
Since Don has an offer but has not entered into any sales contract with the prospective buyer of the 20 lots, it is still possible to set up a unitrust and avoid prearranged sale problems.
Don created the first unitrust with the lots and his CPA serves as initial trustee. Don deeded the 20 lots to the CPA as trustee and the CPA, four weeks later, sold to a new buyer for $600,000.
Since these lots represented inventory, or ordinary income for the excess of $600,000 over the $100,000 cost basis of the lots, Don would report $500,000 of ordinary income if he sold outside the trust. However, by selling inside the trust, Don saves the tax otherwise payable on $500,000. Plus, Don receives a charitable income tax deduction. The income tax deduction for an inventory asset is limited to cost basis times the factor. So Don's deduction with a factor of .4000 is that number times $100,000, or $40,000.
Don also has the property that was owned for four years and could be sold as a single block to a new buyer. Since the 80-acre parcel has been owned for a number of years, Don's CPA determines that he is an investor with respect to that property. Because the first unitrust has received ordinary income property and, upon sale, the Tier 1 ordinary income amount is $500,000, that trust will pay out ordinary income taxable at the top income tax bracket. Therefore, Don's CPA suggested setting up a second unitrust for the investor real estate. The second unitrust received the investor real estate and sold to a new buyer for $2 million, once again with the CPA as the initial trustee. By having the CPA as the initial trustee, there are minimal risks that the IRS can claim a prearranged sale with respect to the transfer.
The good news about unitrust two is that the capital gain asset results in an allocation of all of the capital gain to Tier 2. Both of these trusts are FLIP unitrusts, and on the next January 1, the trusts change to straight unitrusts with a 6% payout. Unitrust 2 can be invested primarily in stocks and the majority of the payout will be dividends or long-term capital gain taxable at 15%.
Don is pleased that his CPA was perceptive in recommending the two different trusts. While the first trust saved substantial ordinary income tax, it will pay out ordinary income for the life of the trust. But the second trust bypassed capital gain and will pay mostly dividend and long-term capital gain income for the life of the trust.
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