Taxpayers have relied on restricted management accounts (RMAs) as part of their estate plans for years. Authors William Probus and Jeremy Noetzel explain why RMAs may no longer be appropriate vehicles for accomplishing taxpayers' financial goals.

RMAs have been used recently to accomplish a variety of investment and estate planning objectives, particularly by taxpayers interested in minimizing gift and estate taxes on the transfer of assets through the use of valuation discounts. The Internal Revenue Service (IRS), however, recently ruled that valuation discounts are not available for interests in RMAs. While RMAs are no longer a viable method of obtaining valuation discounts for gift and estate tax purposes, they continue to provide other investment benefits. Taxpayers and their legal and tax counsel should consider alternative strategies for minimizing gift and estate taxes on the transfer of assets. However, RMAs retain certain benefits that should be considered.

RMA Basics

Under an RMA agreement, an individual transfers assets – generally marketable securities – to an investment manager and relinquishes control over the assets for a fixed term. The investment manager retains the sole right to manage the account and make investment decisions during that term, which can generally be extended by the investor. During the RMA term, the investor is normally unable to make withdrawals unless those withdrawals were specifically agreed to in the provisions of the RMA contract, and any income earned by the RMA is retained and reinvested. The investor can transfer the RMA or interests therein to family members, but the restrictions on the transferred RMA remain in place throughout the duration of the RMA term.

RMAs can provide certain financial benefits. For example, with the investor locked in, the investment manager has an incentive to focus on long-term strategies rather than short-term results. Furthermore, because the manager's fees are based on the value of the portfolio rather than the number of transactions, the investor might enjoy lower fees.

RMAs also have been attractive to individuals looking to secure valuation discounts that reduce the amount of gift and estate taxes on their asset transfers. After forfeiting control of those assets, an RMA investor might previously have taken valuation discounts of up to 15 percent of the value of the assets for gift and estate taxation purposes.

Valuation Discounts For Asset Transfers

Individuals in search of such valuation discounts have long turned to family limited partnerships (FLPs) and limited liability companies (LLCs). Initially, RMAs were used in conjunction with FLPs and LLCs. An individual would transfer assets into an RMA, which would itself then be transferred to an FLP or LLC. Or the individual could first transfer the assets into an FLP or LLC, which would then transfer the assets into an RMA.

As the IRS increased its challenges to the validity of FLPs and LLCs, however, individuals began to establish RMAs independent of the other entities. But recently the IRS has turned its attention to the validity of valuation discounts for interests in RMAs as well.

IRS Revenue Ruling 2008-35

On July 21, 2008, the IRS addressed in Revenue Ruling 2008-35 the availability of discounts for RMA interests. Specifically, it considered whether, in determining the value for federal gift and estate tax purposes, the restrictions imposed by an RMA agreement result in a value that is less than the full fair market value of the assets in the RMA. The IRS concluded that they do not.

The IRS held that the existence of an RMA agreement does not reduce the fair market value of the transferred assets for gift or estate tax purposes. At all times, the investor retains a property interest in, and remains the outright owner of, the assets and income from the assets. The investment manager has no property interest in the assets, and the investor has not changed the nature of the assets by entering the RMA agreement.

The IRS made an analogy between the RMA relationship and that of a property owner and its property manager. The existence of the property management contract has no effect on the fair market value of the real property subject to the contract. Likewise, any restrictions imposed by an RMA agreement relate primarily to the performance of the management contract and do not constitute substantive restrictions on the underlying assets. The restrictions do not affect the price at which those assets would change hands between a willing buyer and willing seller and thus do not affect the value of RMA assets.

Alternative Estate Planning Strategies

Once the terms on any existing RMAs expire, investors can pursue alternative strategies for minimizing the taxes on the assets in those RMAs. Despite IRS challenges, FLPs and LLCs are legitimate vehicles for transferring assets. If established and operated properly, FLPs and LLCs can garner valuation discounts of as much as 25 to 35 percent for marketable securities. To survive an IRS audit, an FLP or LLC should be established for a valid business purpose, comply with the provisions of the operating agreement, and observe legal formalities, among other requirements.

A former RMA investor could also create a grantor retained annuity trust (GRAT) to reduce taxes on asset transfers. A GRAT is an irrevocable trust funded by the grantor's one-time contribution of assets. The trust pays the grantor an annuity for a specific term; at term's end, any remaining trust assets transfer tax-free to the designated beneficiaries. Rather than paying the gift tax when the assets actually transfer at term's end, the gift tax is assessed when the trust is created. The tax is based on the present value of the beneficiaries' remainder interest in the trust, calculated using IRS-determined interest rates.

Ideally, the transferred assets appreciate at a rate greater than the IRS interest rates, so that excess appreciation passes to the beneficiaries tax-free. Tax benefits therefore result if the assets' value at term's end exceeds the assets' gift-tax value when the GRAT was funded. To illustrate, a grantor could contribute $1 million to a GRAT that holds the funds in an asset allocation fund for a 10-year term. The grantor will receive a 5 percent annuity payment each year, making the full value of the transfer for gift-tax purposes less than $1 million. If the funds grow at an annual rate equal to or greater than 5 percent, though, the beneficiaries will receive $1 million or more at the term's end.

Future Use Of RMAs

Since the IRS ruling, RMAs are no longer viable vehicles for obtaining valuation discounts, but valid reasons remain for establishing RMAs. An RMA is an effective tool for restricting assets. An RMA can also prove useful for individuals whose family members are not savvy investors. The family members will likely earn a greater return both before and after the investor's death if the assets are placed in an RMA. And investors might use RMAs simply to see better returns, at a lower charge, for themselves. Attorneys should be mindful of these new restrictions, as well as the remaining benefits, when advising their tax clients.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.