Friday, June 28, 2013
2013 midyear tax update – : Individual, trust, and estate tax planning
Baker Tilly write: As we near the middle of the year, tax planning remains complicated. Consequently, we’ve divided our midyear tax letter into three separate parts in order to thoroughly address this year’s most critical issues. The first installment discussed how businesses should plan in light of tax reform and expiring tax provisions. The second part covered health care reform, including the 3.8 percent Medicare tax and pay-or-play regulations. This, our final installment, outlines the implications of the American Taxpayer Relief Act of 2012 (ATRA) on individual, trust, and estate tax planning.
We also kick off a series focusing on business owners, based on the Baker Tilly International network’s global survey to examine the dynamics, barriers, and success strategies of business owners planning for their transitions. In the coming months, we will share survey results and planning recommendations as part of our Succession Insights program.
If you have any questions related to the issues discussed in this or the previous installments of our midyear tax letter, we encourage you to contact your Baker Tilly advisor.
Visit the links below for more on the most critical issues in individual, trust, and estate planning:
- Succession Insights: Integrated financial planning for business owners
- Individual tax planning
- Estate planning
- Tax planning for trusts
- The importance of accurate gift reporting
Succession Insights: Integrated financial planning for business owners Planning for business succession—essentially, strategic planning for the future of your business and your family—involves more than arranging for the transfer of ownership and begins well before a transfer may even be contemplated. While your business will certainly be directly affected by an ownership transition, your decisions will also impact your family’s finances and future. For this reason, business succession planning naturally begins from other planning considerations, such as risk management, investment planning, cash flow and budgeting, cost and tax effective leverage, retirement savings, estate planning, and charitable planning, as it is difficult to develop a sound plan without having developed an overall financial plan for both business and personal matters.
The integrated financial planning model involves defining aspirations in each area of your financial plan and developing strategies to achieve them. Specific and measurable goals make it possible to take concrete steps in achieving your objectives. And, once you have established your overall financial objectives, determining goals for the future of your business will be much more straightforward. Of key importance is integrating these personal and business planning goals since they are parallel, but can also be intertwined, as illustrated below.
The integrated financial planning model involves defining aspirations in each area of your financial plan and developing strategies to achieve them. Specific and measurable goals make it possible to take concrete steps in achieving your objectives. And, once you have established your overall financial objectives, determining goals for the future of your business will be much more straightforward. Of key importance is integrating these personal and business planning goals since they are parallel, but can also be intertwined, as illustrated below.
Click on image to enlarge.
Why integrated planning is importantSmart planning is critical to building value; it is also critical to retaining value. According to Forbes, only 209, or 52 percent, of America’s 400 wealthiest individuals in 2000 were still among the wealthiest in 2010. While some were displaced due to death or shifting assets, most fell off the list because their wealth didn’t increase fast enough or due to over-concentration, over-leveraging, over-spending, taxation, family discord, or liability suits.
Risks like these can typically be managed and mitigated by disciplined planning; however, the key prerequisite for protecting your assets in the context of evolving economic and business conditions is consideration of the totality of the financial picture. The best advice will provide only partial benefits or may even prove detrimental unless it is applied holistically. And tax laws and business decisions can have profound effects on your personal finances. Still, conventional planning approaches may tend to segregate the business and personal spheres.
As a result, certain planning activities tend to get attention, while others are neglected. It is not unusual for an entrepreneur with a well-considered estate plan to lack a clear business succession strategy, or for her to have established effective risk management and hedging strategies for the business yet overlook her family’s personal assets. What’s needed is a comprehensive approach that leverages the similarities and dependencies between business and personal planning to save time and expense and more effectively meet all of your goals.
An integrated financial planning approach engages dedicated, ongoing oversight to review, monitor, and congruently adjust business and personal financial plan implementation by establishing a team, developing integrated financial statements, and formulating a unified set of goals.
Your integrated advisory teamBusiness financial teams are generally composed of a head of finance, business managers, attorneys, CPAs, bankers, investment advisors, insurance specialists, and others. Personal financial teams should include many of the same roles.
Risks like these can typically be managed and mitigated by disciplined planning; however, the key prerequisite for protecting your assets in the context of evolving economic and business conditions is consideration of the totality of the financial picture. The best advice will provide only partial benefits or may even prove detrimental unless it is applied holistically. And tax laws and business decisions can have profound effects on your personal finances. Still, conventional planning approaches may tend to segregate the business and personal spheres.
As a result, certain planning activities tend to get attention, while others are neglected. It is not unusual for an entrepreneur with a well-considered estate plan to lack a clear business succession strategy, or for her to have established effective risk management and hedging strategies for the business yet overlook her family’s personal assets. What’s needed is a comprehensive approach that leverages the similarities and dependencies between business and personal planning to save time and expense and more effectively meet all of your goals.
An integrated financial planning approach engages dedicated, ongoing oversight to review, monitor, and congruently adjust business and personal financial plan implementation by establishing a team, developing integrated financial statements, and formulating a unified set of goals.
Your integrated advisory teamBusiness financial teams are generally composed of a head of finance, business managers, attorneys, CPAs, bankers, investment advisors, insurance specialists, and others. Personal financial teams should include many of the same roles.
Click on image to enlarge.
A key objective is to apply similar business planning expertise and discipline to the personal sphere, making communication and coordination across both spheres critical. An advisor (or advisors) with the ability to handle business and personal financial matters can advantageously manage your global financial picture to preserve and build your capital, protect your family and business, and maximize tax efficiencies.
Building the blueprint – Picturing the integrated financial situationBusiness owners are familiar with using and reviewing balance sheets, income statements, tax projections, budgets, and other financial statements during their routine business activities. Disciplined financial management is crucial for successful businesses. Applying the same comprehensive financial analysis to the personal sphere can make it easier for you and your family to achieve your goals, from funding education costs to planning business succession.
Building the blueprint – Picturing the integrated financial situationBusiness owners are familiar with using and reviewing balance sheets, income statements, tax projections, budgets, and other financial statements during their routine business activities. Disciplined financial management is crucial for successful businesses. Applying the same comprehensive financial analysis to the personal sphere can make it easier for you and your family to achieve your goals, from funding education costs to planning business succession.
Click on image to enlarge.
An integrated set of financial statements constitutes a framework to capture all the significant components of your total financial situation, encompassing assets and liabilities of your household and your business. This framework helps clarify how changes in economic conditions and tax laws, as well as family status and business decisions, could affect your ability to sustain your lifestyle. In addition, you will be better equipped to meet business and personal objectives and respond to unforeseen events. This framework helps to make your goals and objectives concrete and measurable.
Whether you are just becoming established, mid-career, planning for transition, or in the process of transferring wealth to children or charities, the essential components of the balance sheet are similar and speak volumes toward planning needs:
Whether you are just becoming established, mid-career, planning for transition, or in the process of transferring wealth to children or charities, the essential components of the balance sheet are similar and speak volumes toward planning needs:
- Taxable investment assets, such as cash, marketable securities, restricted stock, and hedge funds
- Lifestyle assets, such as tangible property and personal residences
- Business assets, such as the value of your company, property, and private equity investments
- Tax-deferred assets such as 401(k)s and IRAs
- Insurance, such as life insurance cash value and death benefits
- Liabilities such as mortgages, private equity capital commitments, and income and estate tax
Below, the integrated balance sheet shows the allocation of your assets across multiple dimensions: family members, business and personal sources, and estate-includible and non-includible categories.
Click image to enlarge.
With this snapshot of your total financial situation, you can not only assess your family’s overall holdings and multiple sources of income, but also understand how different types of assets impact your liquidity, tax burden, and cash flow. Once you have an integrated balance sheet, you can more easily shift components based on your planning objectives. For example, if your integrated balance sheet makes the size of the taxable portion of your estate apparent, a planning goal might be to shift assets from the includible (left side of the balance sheet) to the non-includible (right side) through wealth transfer and/or charitable planning. Similarly, you may want to maximize tax-deferred investments in a "qualified retirement plan," annuities, or other tax-preferred investments and place as many assets from the non-qualified category (currently taxable) into the qualified category (tax-preferred).
The family balance sheet used in conjunction with tools like income statements, itemized tax projections, outlines of your estate plan, and reports of cash inflows and outflows, represent your integrated financial statements and provide insight into the key components of your financial picture. It becomes a straightforward matter to see how potential problem areas such as concentration risk, tax liabilities, or debt-to-equity ratio can affect your personal goals as well as your business objectives.
The benefits of integrated financial planning are considerable. Building these financial statements (the blueprint), assembling your team, and outlining your goals are only the first steps. While we focus on many tax planning considerations in this portion of our midyear tax letter, we will share results from the survey and related planning suggestions in the coming months.
The family balance sheet used in conjunction with tools like income statements, itemized tax projections, outlines of your estate plan, and reports of cash inflows and outflows, represent your integrated financial statements and provide insight into the key components of your financial picture. It becomes a straightforward matter to see how potential problem areas such as concentration risk, tax liabilities, or debt-to-equity ratio can affect your personal goals as well as your business objectives.
The benefits of integrated financial planning are considerable. Building these financial statements (the blueprint), assembling your team, and outlining your goals are only the first steps. While we focus on many tax planning considerations in this portion of our midyear tax letter, we will share results from the survey and related planning suggestions in the coming months.
Individual tax planning The new tax law ushered in a number of tax changes for individuals. In addition to raising the top ordinary tax bracket to 39.6 percent for taxpayers with income in excess of $450,000 for married filing jointly and $400,000 for single filers, it addresses the capital gains rate, tax rates for dividends, and numerous other tax provisions.
The following are the key provisions from the American Taxpayer Relief Act of 2012 (ATRA), a refresher on the Medicare taxes coming into play this year, as well as planning considerations.
Individual tax provisionsTax rates. For 2013, the top rate rises to 39.6 percent for taxpayers above the "applicable threshold." The applicable threshold is $450,000 for married filing jointly, $400,000 for single filers, $425,000 for heads of household, and $225,000 for married filing separately.
The following are the key provisions from the American Taxpayer Relief Act of 2012 (ATRA), a refresher on the Medicare taxes coming into play this year, as well as planning considerations.
Individual tax provisionsTax rates. For 2013, the top rate rises to 39.6 percent for taxpayers above the "applicable threshold." The applicable threshold is $450,000 for married filing jointly, $400,000 for single filers, $425,000 for heads of household, and $225,000 for married filing separately.
| Tax rate | Married filing jointly | Single | Head of household | Married filing separately |
| 10% | $0 - $17,850 | $0 - $8,925 | $0 - $12,750 | $0 - $8,925 |
| 15% | $17,850 - $72,500 | $8,925 - $36,250 | $12,750 - $48,600 | $8,925 - $36,250 |
| 25% | $72,500 - $146,400 | $36,250 - $87,850 | $48,600 - $125,450 | $36,250 - $73,200 |
| 28% | $146,400 - $223,050 | $87,850 - $183,250 | $125,450 - $203,150 | $73,200 - $111,525 |
| 33% | $223,050 - $398,350 | $183,250 - $398,350 | $203,150 - $398,350 | $111,525 - $199,175 |
| 35% | $398,350 - $450,000 | $398, 350 - $400,000 | $398,350 - $425,000 | $199,175 - $225,000 |
| 39.6% | Over $450,000 | Over $400,000 | Over $425,000 | Over $225,000 |
Capital gains and qualified dividend rates. Beginning in 2013, the top rate for capital gains and qualified dividends permanently rose to 20 percent (up from 15 percent) for taxpayers with incomes exceeding the "applicable threshold" as discussed above.
| Rate | |
| Taxpayers in 39.6% income tax bracket | 20% |
| Taxpayers in 15% to 35% income tax bracket | 15% |
| Taxpayers in 10% and 15% income tax bracket | 0% |
Itemized deduction limitation. ATRA reinstated the "Pease" limitation on most itemized deductions with a starting threshold based on adjusted gross income of $300,000 for married filing jointly, $250,000 for single filers, $275,000 for heads of household, and $150,000 for married filing separately. For taxpayers subject to the Pease limitation, the total of their affected itemized deductions is reduced by the smaller of 3 percent of the amount by which the taxpayer’s adjusted gross income exceeds the threshold amount or 80 percent of itemized deductions that are affected by the limit.
Personal exemption limitation. The personal exemption phase-out (PEP), which was previously suspended, is reinstated with a starting threshold of $300,000 for married filing jointly, $250,000 for single filers, $275,000 for heads of household, and $150,000 for married filing separately. Under the phase-out, the total amount of exemptions that can be claimed by a taxpayer subject to the limitation is reduced by 2 percent for each $2,500 (or portion thereof) by which the taxpayer’s income exceeds the applicable threshold. These dollar amounts are inflation-adjusted for tax years after 2013. In 2013, the personal exemption amount is $3,900.
Permanent AMT relief. ATRA provided permanent AMT relief for 2012 and beyond. In addition, beginning with 2013, these exemption amounts are indexed for inflation.
Personal exemption limitation. The personal exemption phase-out (PEP), which was previously suspended, is reinstated with a starting threshold of $300,000 for married filing jointly, $250,000 for single filers, $275,000 for heads of household, and $150,000 for married filing separately. Under the phase-out, the total amount of exemptions that can be claimed by a taxpayer subject to the limitation is reduced by 2 percent for each $2,500 (or portion thereof) by which the taxpayer’s income exceeds the applicable threshold. These dollar amounts are inflation-adjusted for tax years after 2013. In 2013, the personal exemption amount is $3,900.
Permanent AMT relief. ATRA provided permanent AMT relief for 2012 and beyond. In addition, beginning with 2013, these exemption amounts are indexed for inflation.
| Before ATRA | After ATRA | |
| Married filing jointly | $45,000 | $80,800 |
| Single | $33,750 | $51,900 |
| Married filing separately | $22,500 | $40,400 |
Other individual provisions. The $3,000 child and dependent care credit ($6,000 for more than one child), the exclusion for employer-provided educational assistance, and the employer-provided child care credit were also extended and made permanent as part of the legislation. Additionally, the deduction for state and local general sales taxes, the exclusion from gross income of discharge of qualified principal residence indebtedness, and the above-the-line deduction for qualified tuition and related expenses were extended through 2013.
Conversion of 401(k) balances to a Roth account. ATRA allows the conversion of amounts in 401(k) plans and certain other employer retirement accounts into Roth accounts. The amounts converted will be subject to income tax. Under ATRA the transfer is treated as a taxable qualified rollover contribution. A conversion can only take place if an employer plan sponsor makes this plan feature available.
The common thresholds to keep in mind are:
Conversion of 401(k) balances to a Roth account. ATRA allows the conversion of amounts in 401(k) plans and certain other employer retirement accounts into Roth accounts. The amounts converted will be subject to income tax. Under ATRA the transfer is treated as a taxable qualified rollover contribution. A conversion can only take place if an employer plan sponsor makes this plan feature available.
The common thresholds to keep in mind are:
| Married filing jointly | Single | |
| 39.6% income tax bracket | $450,000 | $400,000 |
| Pease/PEP limitations | $300,000 | $250,000 |
| AMT exemption | $80,800 | $51,900 |
| 3.8% / 0.9% Medicare taxes | $250,000 | $200,000 |
The Medicare tax and the surtaxThe new Medicare tax created by the health care reform legislation passed in 2010 took effect Jan. 1, 2013. The hospital insurance portion of the payroll tax, commonly referred to as the Medicare portion, increased by 0.9 percent for high-wage individuals. The 0.9 percent payroll tax increase affects those with wages exceeding $250,000 for married filing jointly, $200,000 for single filers, and $125,000 for married filing separately.
Also beginning in 2013, the 3.8 percent Medicare contribution tax (known as the surtax) is imposed on the unearned income of high-income individuals. The 3.8 percent contribution tax on unearned income applies to some or all of the net investment income of individuals with modified adjusted gross income that exceeds $250,000 for married filing jointly, $200,000 for single filers, and $125,000 for married filing separately. The chart below outlines the types of income subject and not subject to the surtax.
Also beginning in 2013, the 3.8 percent Medicare contribution tax (known as the surtax) is imposed on the unearned income of high-income individuals. The 3.8 percent contribution tax on unearned income applies to some or all of the net investment income of individuals with modified adjusted gross income that exceeds $250,000 for married filing jointly, $200,000 for single filers, and $125,000 for married filing separately. The chart below outlines the types of income subject and not subject to the surtax.
| Subject to 3.8% surtax | Exempt from surtax | |
| Wages | X | |
| Active business income | X | |
| Self-emplyment income | X | |
| Gain from sale of active business | X | |
| Gain from sale of investments | X | |
| Retirement plan distributions | X | |
| Taxable interest | X | |
| Exempt interest | X | |
| Dividends | X | |
| Annuity income | X | |
| Passive royalty | X | |
| Active royalty | X | |
| Active business rent | X | |
| All other rents | X |
Summary of tax law in 2013
| Tax rates | 2012 | ATRA 2013 |
| Ordinary income | 39.6% for income over threshold levels1 | |
| 35% | 35% | |
| 33% | 33% | |
| 28% | 28% | |
| 25% | 25% | |
| 15% | 15% | |
| 10% | 10% | |
| Alternative minimum tax2 | 26% / 28% | 26% / 28% |
| Interest | Ordinary income rates | Ordinary income rates |
| Long-term capital gains and qualifying dividends | 20% for income over threshold levels1,3 | |
| 15%3 | 15%3 | |
| 0%3 | 0%3 | |
| Personal exemption phaseout (PEP) | None | Restored |
| Limitations on deductions | None | Restored |
| Health care reform increases | None | 3.8% on investment income4 |
| None | 0.9% on earned income | |
| ||
Planning considerationsOver the past few years we were planning in anticipation of rising tax rates, focusing on accelerating income and deferring deductions to take advantage of lower rates. Now that increased tax rates are here, we are back to deferring income and accelerating deductions in order to reduce exposure to higher rates. Furthermore, taxpayers should weigh the impact of limitations on certain itemized deductions as they may not be as beneficial as they are in a higher rate environment.
Below are some additional planning strategies to keep in mind:
Below are some additional planning strategies to keep in mind:
- Discuss your portfolio with your investment advisor to understand the impact on your total return and after-tax income as a result of the increase in dividend, capital gain, and ordinary rates plus the 3.8 percent tax on net investment income
- Consider the following to reduce exposure to the 3.8 percent Medicare surtax:
- Maximizing contributions to qualified retirement accounts (IRAs, 401(k)s, etc.)
- Using annuities to defer tax
- Using life insurance for its tax-deferred or even tax-free benefits
- Investing in municipal bonds versus corporate bonds
- Consider the after-tax cost of debt: deductible mortgage, business, and investment interest in a higher tax environment may lead to a lower after-tax effective rate of interest
- The after-tax cost of debt can be lower in a higher tax environment
Example: 4% interest rate loan secured by an investment portfolio
a) High tax environment: 43.4% highest tax bracket
b) Low tax environment: 35.0% highest tax bracket
Click image to enlarge.
- The after-tax cost of debt can be lower in a higher tax environment
- Consider charitable planning carefully at year-end: charitable planning in a higher tax environment may lead to lower out-of-pocket costs for gifts to charity; be mindful of the form of gift (cash versus appreciated property); and consider the impact of itemized deduction phase-out reinstated in 2013
- Consider transferring wealth to lower income family members, but be wary of the taxation of trusts discussed later in this article
Estate planning Toward the end of last year, estate planners and their clients were scrambling to implement strategies to take advantage of 2012’s historic rates and exemptions for fear of losing the opportunity. In the end - although estate and gift tax rates increased - ATRA actually increased estate, gift, and generation-skipping transfer (GST) tax exemptions by making permanent the 2012 exemption amount and indexing it for inflation going forward. It also made permanent the portability of the estate exemption between married couples.
While we now know the urgency was somewhat unnecessary, the planning wasn’t and remains an important focus with budget proposals looming that may still limit the generous wealth transfer environment in the future.
In spite of the "permanent" increases to the estate, gift, and GST tax exemption amounts, the Obama administration is proposing restoring 2009 rates, exemptions, and transfer tax law, beginning in 2018. The estate and GST exemptions would be $3.5 million, and the gift tax exemption would be $1 million without indexing for inflation. The top estate, gift, and GST tax rate would be 45 percent. However, portability would remain in effect.
The proposal also includes the following provisions:
While we now know the urgency was somewhat unnecessary, the planning wasn’t and remains an important focus with budget proposals looming that may still limit the generous wealth transfer environment in the future.
In spite of the "permanent" increases to the estate, gift, and GST tax exemption amounts, the Obama administration is proposing restoring 2009 rates, exemptions, and transfer tax law, beginning in 2018. The estate and GST exemptions would be $3.5 million, and the gift tax exemption would be $1 million without indexing for inflation. The top estate, gift, and GST tax rate would be 45 percent. However, portability would remain in effect.
The proposal also includes the following provisions:
- No "clawback" by reason of reducing estate, gift, and GST exemptions—meaning those who use their entire $5.25 exemption amounts today will not lose the benefit
- Basis reporting requirements for donated and inherited property
- Limited availability of valuation discounts for transfers made between related parties
- A 10-year minimum term for grantor retained annuity trusts (GRATs) and requirement for the remainder interest to have a value greater than zero at the time the interest is created
- Eliminate tax benefits associated with the sale to an intentionally defective grantor trust (IDGT)
- Limited duration of GST tax exemption
- Eliminate exclusion for generation-skipping tax purposes of distributions from trusts to providers of medical care or schools for tuition—only payments made directly from donor to the provider of medical care or the school for tuition would be excluded
| Year | Estate tax exemption | Basis method | GST tax exemption | Top estate / GST tax rate | Gift tax exemption | Top gift tax rate |
| 2009 | $3.5 million | Step up in basis | $3.5 million | 45% | $1 million | 45% |
| 2010 | - 0 - | Modified carryover basis | - 0 - | 0% | $1 million | 35% |
| $5 million | Step up in basis | $5 million | 35% | |||
| 2011 | $5 million | Step up in basis | $5 million | 35% | $5 million | 35% |
| 2012 | $5.12 million (portable) | Step up in basis | $5.12 million | 35% | $5.12 million (portable) | 35% |
| 2013 | $5.25 million* | Step up in basis | $5.25 million* | 40% | $5.25 million* | 40% |
| Obama proposal | $3.5 million | Step up in basis | $3.5 million | 45% | $1 million | 45% |
| *Indexed for inflation. | ||||||
Current estate planning opportunitiesIf you have not already taken advantage of the historically high lifetime gift exemption, you should consider implementing a plan while generous opportunities still exist. Because of last year’s uncertainty, many may have already used the 2012 lifetime gift exemption of $5.12 million, but thanks to the higher exemption of $5.25 million, those who did can add $130,000 to that exemption.
For those who have not yet used their lifetime gift exemption, consider outright gifts or gifts to a trust, including:
For those who have not yet used their lifetime gift exemption, consider outright gifts or gifts to a trust, including:
- Establishing a spousal lifetime access trust, which allows your spouse to be a beneficiary of the trust
- Giving assets subject to valuation discounts
- Giving assets to a generation-skipping trust
- Forgiving loans to children or others (to use a portion of the gift tax exemption)
Additionally, consider using freeze strategies such as the aforementioned GRAT or IDGT to make the most of the trusts’ benefits as well as low interest rates while they are still available.
These opportunities will not suit everyone’s situation, but we recommend preparing for the changing tax environment by discussing your situation with us, your attorney, and other advisors.
These opportunities will not suit everyone’s situation, but we recommend preparing for the changing tax environment by discussing your situation with us, your attorney, and other advisors.
Tax planning for trusts ATRA, which was signed into law in the early hours of 2013, is partly retroactive and partly prospective and features a number of provisions that impact the taxation of individuals, trusts, and estates. With increased tax exposure, planning considerations for trusts are even more important going forward. We have outlined below the implications of ATRA and planning considerations.
| Trust taxation 2012 | Trust taxation under ATRA 2013 | ||
| Ordinary income | |||
| Over $11,650 | 35% | Over $11,950 | 39.6% |
| Over $8,500 to $11,650 | 33% | Over $8,750 to $11,950 | 33% |
| Over $5,600 to $8,500 | 28% | Over $5,700 to $8,750 | 28% |
| Over $2,450 to $5,600 | 25% | Over $2,450 to $5,700 | 25% |
| Not over $2,400 | 15% | Not over $2,450 | 15% |
| Alternative minimum tax | 26% / 28% | 26% / 28% | |
| Interest | Ordinary income rates | Ordinary income rates | |
| Long-term capital gains and qualifying dividens | n/a | | 20% for income over $11,950 |
| 15% | 15% | ||
| Health care reform increases | None | 3.8% on investment income1 | |
| |||
ATRA’s changes to income taxationBeginning Jan. 1, 2013, income taxed at the trust level in excess of $11,950 is subject to a federal tax rate of 39.6 percent—an increase of 4.6 percent from a top rate of 35 percent—while individual taxpayers will only pay the 39.6 percent rate for taxable income exceeding $400,000. Similarly, trust long-term capital gains and qualified dividends of trusts are taxed above the $11,950 threshold at the new top rate of 20 percent, which was increased from 15 percent.
Medicare surtax on net investment incomeAs mentioned above, taxpayers also face the 3.8 percent Medicare surtax on unearned income of individuals, trusts, and estates. Effective for years beginning after Dec. 31, 2012, this new tax is imposed on the lesser of:
Medicare surtax on net investment incomeAs mentioned above, taxpayers also face the 3.8 percent Medicare surtax on unearned income of individuals, trusts, and estates. Effective for years beginning after Dec. 31, 2012, this new tax is imposed on the lesser of:
- Annual "undistributed net investment income;" or
- The excess of annual adjusted gross income (AGI) over the dollar amount at which the highest tax bracket begins for the respective tax year.
This means trusts with certain taxable, undistributed income in excess of $11,950 will potentially be subject to three separate taxes: the aforementioned increased regular income tax, the alternative minimum tax (AMT), and the new Medicare surtax.
Post-ATRA planning considerationsDistribution planningWhere the trust allows, consider making favorable distributions to beneficiaries who are below the higher individual Medicare surtax thresholds as well as below the higher regular tax and AMT thresholds.
Capital gains planningIn recent years, trusts enjoyed a maximum long-term capital gains rate of 15 percent, but with ATRA, this maximum rate increased to 23.8 percent (20 percent top rate plus the 3.8 percent Medicare surtax). Often, net capital gains of trusts are considered principal, not income and are not distributed to beneficiaries. For this reason, the gains are taxable at the trust level rather than to the beneficiaries. However, some trusts may be allowed to treat capital gain as income, distributing that amount to a beneficiary and taxing it according to their tax brackets and thresholds. This may be possible where:
Post-ATRA planning considerationsDistribution planningWhere the trust allows, consider making favorable distributions to beneficiaries who are below the higher individual Medicare surtax thresholds as well as below the higher regular tax and AMT thresholds.
Capital gains planningIn recent years, trusts enjoyed a maximum long-term capital gains rate of 15 percent, but with ATRA, this maximum rate increased to 23.8 percent (20 percent top rate plus the 3.8 percent Medicare surtax). Often, net capital gains of trusts are considered principal, not income and are not distributed to beneficiaries. For this reason, the gains are taxable at the trust level rather than to the beneficiaries. However, some trusts may be allowed to treat capital gain as income, distributing that amount to a beneficiary and taxing it according to their tax brackets and thresholds. This may be possible where:
- Capital gains are allocated to income by the governing instrument and/or local law;
- The trustee has discretion to allocate capital gains to income under the governing instrument and/or local law;
- The trustee consistently distributes capital gains to a beneficiary; and/or
- The trustee actually distributes the capital gains to a beneficiary or utilizes the capital gains to determine an amount distributed (or required to be distributed) to a beneficiary.
Your tax professional and your attorney can determine whether the trust was designed (or can be reformed) to permit capital gains to be allocated to income. If an allocation is permissible and it meets the goals and objectives of the family and trust, distributing capital gains to a beneficiary may provide a tax savings for the trust and its beneficiaries.
Passive vs. nonpassive activity considerationsAn additional Medicare surtax planning strategy for trusts involves classifying certain types of income as passive or nonpassive because nonpassive income is not considered net investment income subject to the surtax. Passive activities are business activities in which the owner does not materially participate (i.e., is not involved in the operations of the business on a regular, continuous, and substantial basis). Trusts and estates may be treated as materially participating in an activity if an executor or trustee satisfies the relevant criteria. Unfortunately, this is not a "bright line" test, and the IRS has been very reluctant to allow active treatment to trusts. An active position requires careful planning and consideration of risk so now is the time to consider whether the trust will treat this income as coming from a passive or nonpassive activity, and plan accordingly.
Nontax reasons to establish a trustWith the increased exposure to top tax rates and the Medicare surtax, it might initially seem that establishing and maintaining trusts would be less useful. However, the nontax benefits of trusts remain invaluable. Beyond avoiding estate taxes, a trust can help to avoid probate, provide for professional management of assets, provide for minor children, keep assets within a family bloodline, and protect assets from creditors. The necessity and utility of one of these benefits may far outweigh the additional tax exposure.
Nontax reasons to establish a trustWith the increased exposure to top tax rates and the Medicare surtax, it might initially seem that establishing and maintaining trusts would be less useful. However, the nontax benefits of trusts remain invaluable. Beyond avoiding estate taxes, a trust can help to avoid probate, provide for professional management of assets, provide for minor children, keep assets within a family bloodline, and protect assets from creditors. The necessity and utility of one of these benefits may far outweigh the additional tax exposure.
The importance of accurate gift reportingPrior to the enactment of ATRA, which made permanent the $5 million indexed estate, gift, and generation-skipping transfer tax exemption amounts, the uncertainty that existed at the end of 2012 regarding the gift and the estate tax law spurred many to engage in significant and complicated estate planning. Now, in 2013, those individuals face the task of "completing" their estate planning by appropriately reporting those transactions.
Statute of limitations and adequate disclosureWhen making gifts, especially large gifts or gifts of hard-to-value assets, it is important to report them on a properly filed gift tax return (Form 709) to start the clock on the statute of limitations. For a gift tax return, the statute of limitations is generally three years after the return is filed. However, merely filing the Form 709 is insufficient. For the statute of limitations to run for a gift, it must be adequately disclosed on the gift tax return (or an attached statement) filed for the year of the gift.
When a gift is "adequately disclosed," the Internal Revenue Service (IRS) cannot revalue the gift nor make adjustments involving other issues, such as annual exclusion applicability, after the three-year statute of limitations has expired. However, if a gift is not adequately disclosed, then the IRS can make adjustments for an indefinite period of time.
The reach of the IRS and the importance of adequately disclosing gifts properly on gift tax returns was highlighted recently in a Tax Court case. In the case, the IRS assessed more than $1 million in back taxes as a result of gifts a taxpayer made to his children in 1972. Since the taxpayer never filed a gift tax return to report the gifts, the statute of limitations did not run and the IRS could still assess the tax more than 40 years later.
Adequate disclosure requirements Stated simply, adequate disclosure requires that the nature of the gift made be outlined along with the valuation method used in determining the gifted asset’s value. Pursuant to Treasury regulations, a transfer is considered adequately disclosed if the return or attached statement provides the following information:
Statute of limitations and adequate disclosureWhen making gifts, especially large gifts or gifts of hard-to-value assets, it is important to report them on a properly filed gift tax return (Form 709) to start the clock on the statute of limitations. For a gift tax return, the statute of limitations is generally three years after the return is filed. However, merely filing the Form 709 is insufficient. For the statute of limitations to run for a gift, it must be adequately disclosed on the gift tax return (or an attached statement) filed for the year of the gift.
When a gift is "adequately disclosed," the Internal Revenue Service (IRS) cannot revalue the gift nor make adjustments involving other issues, such as annual exclusion applicability, after the three-year statute of limitations has expired. However, if a gift is not adequately disclosed, then the IRS can make adjustments for an indefinite period of time.
The reach of the IRS and the importance of adequately disclosing gifts properly on gift tax returns was highlighted recently in a Tax Court case. In the case, the IRS assessed more than $1 million in back taxes as a result of gifts a taxpayer made to his children in 1972. Since the taxpayer never filed a gift tax return to report the gifts, the statute of limitations did not run and the IRS could still assess the tax more than 40 years later.
Adequate disclosure requirements Stated simply, adequate disclosure requires that the nature of the gift made be outlined along with the valuation method used in determining the gifted asset’s value. Pursuant to Treasury regulations, a transfer is considered adequately disclosed if the return or attached statement provides the following information:
- A description of the transferred property and any consideration received by the donor;
- The identity of and the relationship between the donor and each donee;
- If the property is transferred in trust, the trust’s tax identification number and a brief description of the terms of the trust, or in lieu of a brief description of the trust terms, a copy of the trust instrument;
- Either a qualified appraisal/valuation or a detailed description of the method used to determine the fair market value of the property transferred, including any financial data, any restrictions on the transferred property, and any discounts;
- A statement describing any position taken that is contrary to any proposed, temporary, or final Treasury regulations or revenue rulings published at the time of the transfer.
Although deceptively straightforward, the adequate disclosure requirements are more complicated than they appear. This is especially true with regard to the requirement concerning the method used to determine the gifted asset’s value. A timely and well-prepared valuation report fulfills this requirement best, especially when a valuation discount is claimed. Other valuation mechanisms, if less detailed than a valuation report, are not as strong and may not meet adequate disclosure requirements. They also don’t support a valuation discount.
This is further amplified if, for example, a business owner was using a sophisticated part-gift, part-sale transaction, which contained an overflow mechanism, to transfer his closely held company stock to his son. The increased complexity in the structure of the transaction requires that even greater attention be paid to ensuring that the adequate disclosure requirements are being met. For instance, we would recommend reporting the sale portion of the transaction on the gift tax return as a zero gift, in addition to the gift portion. We would also recommend disclosing in the gift description the terms of the overflow mechanism to ensure that the IRS is apprised of both the nature of the transfer and the mechanism used to determine the value of the transfer.
As is evident, care must be taken when preparing gift tax returns to ensure that the adequate disclosure requirements are being met. In our experience, valuation is the principal challenge that the IRS mounts in most audits of gift tax returns. However, as stated in a recent IRS announcement, it has embarked on a new initiative to audit returns for the adequate disclosure requirements. Therefore, it is even more important than ever to adhere to adequate disclosure requirements and to start the statute of limitations on a transfer.
Generation-skipping transfersAnother important reason to file a gift tax return is to ensure the donor’s generation-skipping transfer (GST) tax exemption is allocated accurately as intended in the estate plan.
Assets passed from one generation to the next are taxed with each transfer, and when one generation is bypassed and gifts are made to "skip" persons, the federal government imposes a GST tax. A "skip" (bypassed) person is defined as a person two or more generations younger than the donor or a nonrelative more than 37 and a half years younger than the donor. The GST tax rate is currently a flat 40 percent, but it is in addition to any gift or estate taxes on the same transfer. In reality, the IRS says if you can skip a generation, you need to then pay/prepay the transfer tax. The disadvantage is that the tax may be due immediately and at the 40 percent rate.
Generally, a donor’s GST tax exemption is automatically allocated to direct gifts to skip persons, made either outright to an individual or in trust for their benefit. If a donor has no remaining GST tax exemption available to allocate to a direct skip transfer, GST tax is due immediately with the transfer. A donor’s GST tax exemption may also be allocated to gifts to trusts in which skip persons and non-skip persons hold beneficial interests. These gifts are called indirect skip gifts and are gifts made to trusts. Unlike direct skip gifts, if a donor’s GST tax exemption is not allocated to these transfers, GST tax is not immediately due. Rather, the GST tax is imposed on future distributions from these trusts to skip persons. Allocation to these gifts to trusts can avoid the GST tax later when distributions are made.
Many of the large transfers that occurred at the end of 2012 encompassed indirect skip gifts to trusts which may benefit skip persons, such as grandchildren. Due to the size of the transfers and the trust terms, in many instances the estate planning that prompted the gifts anticipated that the donor’s GST tax exemption would be allocated to the transfers—thus preventing future trust distributions from being subject to the GST tax. Unless the terms of the trust qualify it for automatic allocation of the donor’s GST tax exemption, an election needs to be made with a timely filed gift tax return in order for the exemption to be allocated to the transfer. Further, even if the terms of the trust qualify it for automatic allocation, we generally recommend that an election be made on a timely filed gift tax return to affirmatively allocate the donor’s GST tax exemption. Doing so negates any question as to the donor’s intent regarding the allocation of their GST tax exemption.
Additionally, the estate plan might have envisioned electing out of automatic allocation if the situation was such that the estate planner and the taxpayer did not feel that allocating the donor’s GST tax exemption to the transfer was beneficial. In this case, if the terms of the trust qualified the trust for automatic allocation of the donor’s GST tax exemption, an election needs to be filed with a timely filed gift tax return to elect out of the automatic allocation of the donor’s GST tax exemption to the transfer.
The importance of proper GST tax exemption allocation can be seen in the previous example of the business owner who was using a part-gift, part-sale transaction to transfer his closely held company stock to his son. For purposes of this example, assume that the transfer was not outright to the individual’s son, but rather to a trust for his benefit and the benefit of his children and grandchildren. Considering that the trust benefits skip generations, the intent when creating the estate plan was for the business owner to utilize a portion of his lifetime GST tax exemption on the transfer. The purpose of allocating the donor’s GST tax exemption to the transfer is to ensure that future distributions from the trust to skip persons will not be subject to the GST tax. If the donor’s GST tax exemption was not allocated to the transfer, all future distributions made from the trust to skip persons would be subject to the GST tax. The tax is due at the time of the distribution.
In the example above, we recommend making the allocation prospective and also on a formula basis such that the allocation would change based upon any subsequent revaluing of the transferred asset (i.e., the company stock). Additionally, in certain situations, we may also advise clients to elect to allocate GST tax exemption not just to the gift portion of the transfer, but also to the sale portion of the transfer. Therefore, if upon revaluation, the IRS should ever treat a portion of the sale as a gift, based upon the GST tax allocation election and the formula allocation, GST tax exemption would be automatically allocated to any subsequent gift to the trust. Thus, maintaining the GST tax-free nature of future distributions.
Inevitably, GST tax exemption allocations are missed or are made incorrectly. When this happens, the donor has two common remedies to "fix" the GST tax exemption allocation. The "late allocation" and the "retroactive allocation" are available under the Internal Revenue Code and both require additional work, expertise, and research to be performed before they can be used to solve a GST allocation of exemption issue.
A GST tax annual exclusion—like the gift tax annual exclusion—is also available. However, be cautious when planning the use of the GST tax annual exclusion because it is often tied to the use of the gift tax annual exclusion, even though the GST tax annual exclusion will not apply to all the same transfers.
The GST tax and the GST tax exemption allocation are some of the most complicated and difficult areas of the Code. Therefore, care must be taken when preparing gift tax returns in which direct skip gifts or indirect skip gifts are being reported. The misreporting of these gifts could have significant tax consequences, both immediately and in the future.
This is further amplified if, for example, a business owner was using a sophisticated part-gift, part-sale transaction, which contained an overflow mechanism, to transfer his closely held company stock to his son. The increased complexity in the structure of the transaction requires that even greater attention be paid to ensuring that the adequate disclosure requirements are being met. For instance, we would recommend reporting the sale portion of the transaction on the gift tax return as a zero gift, in addition to the gift portion. We would also recommend disclosing in the gift description the terms of the overflow mechanism to ensure that the IRS is apprised of both the nature of the transfer and the mechanism used to determine the value of the transfer.
As is evident, care must be taken when preparing gift tax returns to ensure that the adequate disclosure requirements are being met. In our experience, valuation is the principal challenge that the IRS mounts in most audits of gift tax returns. However, as stated in a recent IRS announcement, it has embarked on a new initiative to audit returns for the adequate disclosure requirements. Therefore, it is even more important than ever to adhere to adequate disclosure requirements and to start the statute of limitations on a transfer.
Generation-skipping transfersAnother important reason to file a gift tax return is to ensure the donor’s generation-skipping transfer (GST) tax exemption is allocated accurately as intended in the estate plan.
Assets passed from one generation to the next are taxed with each transfer, and when one generation is bypassed and gifts are made to "skip" persons, the federal government imposes a GST tax. A "skip" (bypassed) person is defined as a person two or more generations younger than the donor or a nonrelative more than 37 and a half years younger than the donor. The GST tax rate is currently a flat 40 percent, but it is in addition to any gift or estate taxes on the same transfer. In reality, the IRS says if you can skip a generation, you need to then pay/prepay the transfer tax. The disadvantage is that the tax may be due immediately and at the 40 percent rate.
Generally, a donor’s GST tax exemption is automatically allocated to direct gifts to skip persons, made either outright to an individual or in trust for their benefit. If a donor has no remaining GST tax exemption available to allocate to a direct skip transfer, GST tax is due immediately with the transfer. A donor’s GST tax exemption may also be allocated to gifts to trusts in which skip persons and non-skip persons hold beneficial interests. These gifts are called indirect skip gifts and are gifts made to trusts. Unlike direct skip gifts, if a donor’s GST tax exemption is not allocated to these transfers, GST tax is not immediately due. Rather, the GST tax is imposed on future distributions from these trusts to skip persons. Allocation to these gifts to trusts can avoid the GST tax later when distributions are made.
Many of the large transfers that occurred at the end of 2012 encompassed indirect skip gifts to trusts which may benefit skip persons, such as grandchildren. Due to the size of the transfers and the trust terms, in many instances the estate planning that prompted the gifts anticipated that the donor’s GST tax exemption would be allocated to the transfers—thus preventing future trust distributions from being subject to the GST tax. Unless the terms of the trust qualify it for automatic allocation of the donor’s GST tax exemption, an election needs to be made with a timely filed gift tax return in order for the exemption to be allocated to the transfer. Further, even if the terms of the trust qualify it for automatic allocation, we generally recommend that an election be made on a timely filed gift tax return to affirmatively allocate the donor’s GST tax exemption. Doing so negates any question as to the donor’s intent regarding the allocation of their GST tax exemption.
Additionally, the estate plan might have envisioned electing out of automatic allocation if the situation was such that the estate planner and the taxpayer did not feel that allocating the donor’s GST tax exemption to the transfer was beneficial. In this case, if the terms of the trust qualified the trust for automatic allocation of the donor’s GST tax exemption, an election needs to be filed with a timely filed gift tax return to elect out of the automatic allocation of the donor’s GST tax exemption to the transfer.
The importance of proper GST tax exemption allocation can be seen in the previous example of the business owner who was using a part-gift, part-sale transaction to transfer his closely held company stock to his son. For purposes of this example, assume that the transfer was not outright to the individual’s son, but rather to a trust for his benefit and the benefit of his children and grandchildren. Considering that the trust benefits skip generations, the intent when creating the estate plan was for the business owner to utilize a portion of his lifetime GST tax exemption on the transfer. The purpose of allocating the donor’s GST tax exemption to the transfer is to ensure that future distributions from the trust to skip persons will not be subject to the GST tax. If the donor’s GST tax exemption was not allocated to the transfer, all future distributions made from the trust to skip persons would be subject to the GST tax. The tax is due at the time of the distribution.
In the example above, we recommend making the allocation prospective and also on a formula basis such that the allocation would change based upon any subsequent revaluing of the transferred asset (i.e., the company stock). Additionally, in certain situations, we may also advise clients to elect to allocate GST tax exemption not just to the gift portion of the transfer, but also to the sale portion of the transfer. Therefore, if upon revaluation, the IRS should ever treat a portion of the sale as a gift, based upon the GST tax allocation election and the formula allocation, GST tax exemption would be automatically allocated to any subsequent gift to the trust. Thus, maintaining the GST tax-free nature of future distributions.
Inevitably, GST tax exemption allocations are missed or are made incorrectly. When this happens, the donor has two common remedies to "fix" the GST tax exemption allocation. The "late allocation" and the "retroactive allocation" are available under the Internal Revenue Code and both require additional work, expertise, and research to be performed before they can be used to solve a GST allocation of exemption issue.
A GST tax annual exclusion—like the gift tax annual exclusion—is also available. However, be cautious when planning the use of the GST tax annual exclusion because it is often tied to the use of the gift tax annual exclusion, even though the GST tax annual exclusion will not apply to all the same transfers.
The GST tax and the GST tax exemption allocation are some of the most complicated and difficult areas of the Code. Therefore, care must be taken when preparing gift tax returns in which direct skip gifts or indirect skip gifts are being reported. The misreporting of these gifts could have significant tax consequences, both immediately and in the future.
Subscribe to:
Posts (Atom)