Year-End Tax Planning Proves Trickier

CORRIE DRIEBUSCH for the Wall St Journal writes: The year's strong stock market performance means gains for many financial advisers' clients. Now those advisers find themselves with a challenge: how to prepare clients for what could be significantly bigger tax bills.

New, higher income and capital gains tax rates give the issue even more importance. And advisers face a shrinking pool of possible tax losses to harvest and offset those gains. The losses many investors suffered in the 2008 and 2009 financial crisis have been largely used already.

Some financial advisers say that this year they are spending as much as twice the time they typically do sifting through clients' portfolios to look for ways to minimize taxes. They are being forced to be more creative devising strategies to recommend, from donating high-flying stocks to shifting types of investments.

"There are still opportunities [for tax-loss harvesting], but you have to look for them," says Jay Allen, a senior wealth strategist at UBS UBSN.VX +1.27% Wealth Management Americas, who works with financial advisers and their clients on tax-related issues. "Equity markets have performed really well, but not all asset classes have participated in that."

The tax rate hikes and a new 3.8% surcharge on investment income have "caused planning to become much more necessary on a case-by-case basis," says Ben Newhouse, a financial adviser and certified public accountant in Springfield, Mo.

He gives the example of two clients, each making $450,000 a year in taxable income and holding $1 million in an investment portfolio. In one case, the investments are in a taxable brokerage account and the other in tax-deferred IRA accounts. In the past, Mr. Newhouse says he would likely have treated these clients similarly in terms of time and effort when it came to tax preparation. Now, however, the client with the brokerage account would face a significantly higher tax bill and require additional attention.

Jack Oujo, a New Jersey-based financial adviser and CPA, says he anticipates a bigger tax liability for clients with rental properties that have no mortgage and produce steady income. He has helped some of those clients reduce the tax hit by placing property in a limited partnership and then start gifting stakes in the partnership to adult children.

"It becomes imperative for advisers to structure client portfolios strategically," he says. He is emphasizing the need to make full use of tax-deferred accounts and sometimes recommending giving more to charity. When those donations are made in the form of long-term appreciated securities, the client not only gets a tax deduction but also avoids capital gains taxes on the assets.

Investors shouldn't take efforts to reduce taxes to extremes, notes Andrew Ahrens, chief executive of Louisiana-based wealth management firm Ahrens Investment Partners. "What happens is, when clients do massive tax-loss selling, their asset allocation could get out of whack," he says.

Still, Mr. Ahrens says his firm is being especially diligent this year in identifying investments that can and should be sold at a loss now, to offset taxes on gains. They are looking at municipal bonds and other fixed-income products, along with commodities-related investments, which in general have fared relatively poorly this year.

"Last year we would look at holdings and take out big and obvious ones," Mr. Ahrens says. "This year clients are saying, 'Even if we're down only 1% to 2%, just take it [to sell] and we'll buy it back in 30 days.'"

"You can find losses in muni bonds and precious metals, and it's easy to exchange those positions for something similar," says Mr. Oujo.

Tax strategy is something advisers should work on at the start of the year, not just the end, so many are already looking ahead to get their clients in shape for 2014's tax bill.

Mr. Oujo is encouraging muni bonds for high-income earners as a way to shrink tax liability. Though their interest rates are low, most clients who understand how they work appreciate their tax-free status, he says. He is also a proponent of variable annuities, which are often derided, for certain investors.

"It can be a very good strategy for people to invest in the market and avoid taxes on dividends," he says, with the caveat that they have a lot of liquidity with their other investments.

Bryan Stephens, a New York-based financial adviser with UBS, says he puts much of his clients' assets into passive exchange-traded funds, shielding them from big tax hits such as mutual fund distributions. "It's enormously tax efficient," he said.

Tax planning strategies require careful consideration of taxable income

Gordon Dale for the NewsHerald writes: Tax planning presents more challenges than usual this year due to the passage of the American Taxpayer Relief Act of 2012, which was signed into law on Jan. 2, as well as certain tax provisions of the Patient Protection and Affordable Care Act of 2010 taking effect in 2013 and 2014.

Tax planning strategies for individuals this year — and for the next several years — require careful consideration of taxable income in relation to threshold amounts that might bump a taxpayer into a higher or lower tax bracket, thus subjecting him or her to additional taxes such as the Net Investment Income Tax or an additional Medicare tax.

Accelerating deductions

Here are several examples of what a taxpayer might do to accelerate deductions and your lower his or her 2013 income tax liability:

•Pay a state estimated tax installment in December instead of at the January due date. However, make sure the payment is based on a reasonable estimate of your state tax.

•Pay your entire property tax bill, including installments due in year 2014, by year-end. This does not apply to mortgage escrow accounts.

•Try to bunch “threshold” expenses, such as medical and dental expenses (10 percent of AGI starting in 2013) and miscellaneous itemized deductions. For example, you might pay medical bills and dues and subscriptions in whichever year they would do you the most tax good.

Threshold expenses are deductible only to the extent they exceed a certain percentage of adjusted gross income. By bunching these expenses into one year, rather than spreading them out over two years, you have a better chance of exceeding the thresholds, thereby maximizing your deduction.

In cases where tax benefits are phased out over a certain adjusted gross income amount, a strategy of accelerating income and deductions might allow you to claim larger deductions, credits, and other tax breaks for 2013, depending on your situation.

The latter benefits include Roth IRA contributions, conversions of regular IRAs to Roth IRAs, child credits, higher education tax credits and deductions for student loan interest.

Alternate Minimum Tax: The Alternative Minimum Tax exemption “patch” was made permanent by ATRA and is indexed for inflation. It’s important not to overlook the effect of any year-end planning moves on the AMT for 2013 and 2014.

Items that may affect AMT include deductions for state property taxes and state income taxes, miscellaneous itemized deductions, and personal exemptions.

Strategize tuition payments

The American Opportunity Tax Credit, which offsets higher education expenses, was extended to the end of 2017. It may be beneficial to pay 2014 tuition in 2013 to take full advantage of this tax credit, which is up to $2,500 per student.

Residential energy tax credits

Non-business energy credits: ATRA extended the non-business energy credit, which expired in 2011, through 2013 (retroactive to 2012). You may claim a credit of 10 percent of the cost of certain energy saving property that you added to your main home. This includes the cost of qualified insulation, windows, doors and roofs, as well as biomass stoves with a thermal efficiency rating of at least 75 percent.

In some cases, you may be able to claim the actual cost of certain qualified energy-efficient property. Each type of property has a different dollar limit. Examples include the cost of qualified water heaters and qualified heating and air conditioning systems.

To qualify for the credit, your main home must be an existing home located in the United States. New construction and rentals do not qualify. The credit has a maximum lifetime limit of $500; however, only $200 of this limit can be used for windows.

Not all energy-efficient improvements qualify, so be sure you have the manufacturer’s credit certification statement. It is usually available on the manufacturer’s website or with the product’s packaging.

Other year-end moves

Retirement plan contributions: Maximize your retirement plan contributions. If you own an incorporated or unincorporated business, consider setting up a retirement plan if you don’t already have one. (It doesn’t need to actually be funded until you pay your taxes, but allowable contributions will be deductible on this year’s return.)

If you are an employee and your employer has a 401k, contribute the maximum amount ($17,500 for 2013, plus an additional catch up contribution of $5,500 if age 50 or over, assuming the plan allows this much and income restrictions don’t apply).

If you are employed or self-employed with no retirement plan, you can make a deductible contribution of up to $5,500 a year to a traditional IRA (deduction is sometimes allowed even if you have a plan). Further, there is also an additional catch up contribution of $1,000 if age 50 or over.

Health Savings Accounts: Consider setting up a health savings account. You can deduct contributions to the account, investment earnings are tax-deferred until withdrawn, and amounts you withdraw are tax-free when used to pay medical bills.

In effect, medical expenses paid from the account are deductible from the first dollar (unlike the usual rule limiting such deductions to the excess over 10 percent of AGI).

For amounts withdrawn at age 65 or later, and not used for medical bills, the HSA functions much like an IRA. To be eligible, you must have a high-deductible health plan, and only such insurance, subject to numerous exceptions, and must not be enrolled in Medicare.

For 2013, to qualify for the HSA, your minimum deductible in your HDHP must be at least $1,250 (no change in 2014) for single coverage or $2,500 (no change in 2014) for a family.

Summary

These are just a few of the steps you might take. Please contact your CPA for help in implementing these or other year-end planning strategies that might be suitable to your particular situation.

2 Tax Breaks You Can Take Advantage of After Dec. 31

Sean Williams for MotleyFool.com writes: Time certainly flies when you're having fun -- and much fun was to be had this year, with all three major market indexes returning more than 20% year to date and the S&P 500 soaring to a fresh all-time closing high earlier this week.

Two retirement tax breaks you can still take advantage of after Dec. 31!
Christmastime means two things: hustling and bustling malls filled with gift-givers on a mission, and the mad scramble of Americans to get last-second tax items shored up, such as making charitable contributions and tax-loss selling. Although the majority of tax moves for the current year need to be made by Dec. 31 in order to qualify for your 2013 return, there are two important exceptions to this rule.

Traditional IRA & Roth IRA -- deadline April 15, 2014

As if individual retirement accounts didn't already have enough allure, investors can make contributions to both a traditional IRA or Roth IRA (or a combination of both) until April 15, 2014, and still utilize that contribution on their 2013 taxes, if applicable.

Keep in mind that the total contribution to any IRA (or combination) is $5,500 in 2013 and that not all IRA contributions are tax-deductible.

Traditional IRAs allow you to take an upfront tax deduction for your contribution limit, whereas Roth IRAs don't offer an upfront tax deduction. Over the long run, though, retirees who begin taking distributions on their Traditional IRA will pay capital gains taxes on whatever profit their investments have netted, while Roth IRA investments will grow completely tax-free (so long as you don't take your withdrawal before age 59 and a half).

Simplified employee pension -- deadline can be extended until Oct. 15, 2014
A simplified employee pension, or SEP-IRA, is a similar IRA investment option, except it's designed for self-employed individuals or companies that are making contributions on behalf of their employees. Because of the ability to file for a tax extension, people who are SEP-IRA eligible can add to their SEP plan as late as Oct. 15, 2014 and still have it count toward their 2013 contribution. SEP-IRAs allow self-employed people or proprietors to contribute up to 25% of their net earnings -- up to a maximum of $51,000 in 2013. This figure will be raised by $1,000 to $52,000 in 2014. 

IRA ideasOne aspect that both of these late-tax season vehicles share is that they qualify for a full array of investments, including stocks, bonds, and mutual funds, to name a few. As Christmas is but five days away and I'm still in the spirit of giving, here are five stocks for you to consider for your Traditional IRA, Roth IRA, or SEP-IRA.

1. Johnson & Johnson (NYSE: JNJ  )
For those of you who favor consistency and dividends above all else, Johnson & Johnson could be the perfect stock for your IRA. J&J has boosted its dividend in 51 consecutive years and recently purchased Synthes, a medical-device maker, which will give it access to higher-growth emerging markets. Between its strong branded-pharmaceutical growth and the steadiness of its consumer products division, I don't see how investors would lose much sleep at night owning J&J.

2. MasterCard (NYSE: MA  )
If you'd prefer something with a slightly faster growth rate than J&J, payment processing facilitator MasterCard may fit the bill. This payment processor has absolutely no loan liability, so the only thing it needs to focus on is growing the number of merchants in its network and maintaining its pricing power. With much of the world still untapped when it comes to credit- and debit-card usage, MasterCard could be staring down a multidecade double-digit growth opportunity. It also doesn't hurt that the company boosted its quarterly payout by 83% and announced a $3.5 billion share repurchase program last week. 

3. Baidu (NASDAQ: BIDU  )
For younger investors, who may find dividends less appealing, consider search engine Baidu as an intriguing long-term investment. Baidu is China's largest search engine by a mile, and it's poised to take advantage of a growing middle class and a GDP growth figure that has averaged 10% over the past three decades for years to come. When the Chinese mobile Internet market really matures, Baidu could grow from an industry giant to an unstoppable force.

4. Realty Income (NYSE: O  )
For those of you on the other end of the spectrum and nearing your retirement age, perhaps a retail REIT that invests in retail properties and then leases those properties out over the long term could be your calling. The majority of Realty Income's renters are investment grade, and more than half of its rental agreements are setup through at least 2023, so there's little worry about Realty Income's recurring cash flow. With 74 total dividend increases under its belt since 1994, Realty Income's 5.6% yield and monthly dividend could be the perfect recipe for income-seekers.

5. NextEra Energy (NYSE: NEE  )
Finally, if you're a socially conscious investor NextEra Energy might be a decent company to target. Unlike traditional electric utilities which generate the majority of their electricity from coal and natural gas-powered facilities, NextEra is the United States' leading generator of alternative energy (wind, solar, hydroelectric and geothermal). Last year alone, NextEra commissioned its 10,000th MW from wind power. With green energy helping to lower NextEra's costs over the long run, it'll hold a competitive advantage over most of its peers, presumably leaving long-term investors sitting pretty.

2014 Estate, Gift and GST Tax Update: What This Means for Your Current Will, Revocable Trust and Estate Plan

Proskauer Rose writes: we previously reported, the American Taxpayer Relief Act of 2012 (the "Act") made the following permanent: (1) the reunification of the estate and gift tax regimes, (2) the $5 million estate, gift and generation-skipping transfer ("GST") tax exemptions, as increased for inflation (as discussed below), and (3) portability.

Tax Exemption Inflation Increases for 2014

• In 2014, there is a $5,340,000 federal estate tax exemption (increased from $5,250,000 in 2013) and a 40% top federal estate tax rate.
• In 2014, there is a $5,340,000 GST tax exemption (increased from $5,250,000 in 2013) and a 40% top federal GST tax rate.
• In 2014, the lifetime gift tax exemption is $5,340,000 (increased from $5,250,000 in 2013) and a 40% top federal gift tax rate.
• In 2014, the annual gift tax exclusion is $14,000 (no increase from 2013).

These increased exemptions create opportunities to make larger lifetime gifts, to leverage more assets through a variety of estate planning techniques (such as a sale to a grantor trust) and to shift income producing assets to individuals such as children or grandchildren who may be in lower income tax brackets and/or reside in states with a low income tax rate or no state income tax.

Portability

With portability, a deceased spouse's unused estate and gift tax exemption is portable and can be used by the surviving spouse. Portability is intended to prevent families from incurring gift and estate tax that could have been avoided through proper estate planning. The following is an example of portability:

Assume that Husband has $5 million of assets and Wife has $2 million of assets and that portability is not part of the law. Husband dies in 2012 leaving his entire $5 million to his Wife. Even though Husband has an estate of $5 million and a federal estate tax exemption of $5 million (for all purposes of this example, the exemption is not adjusted for inflation), his federal estate tax exemption is wasted because property passing to Wife qualifies for the unlimited federal estate tax marital deduction, and the marital deduction is applied before applying the federal estate tax exemption. Now suppose that Wife dies in 2014, the $5 million that she inherited from Husband had appreciated to $8 million, and her own $2 million remained the same value. Her total estate at her death is now $10 million. Applying her $5 million federal estate tax exemption, the remaining $5 million of her estate would be subject to federal estate tax at 40%, resulting in a tax of $2 million.

Now assume that portability applies upon Husband's death. Because Husband has $5 million of unused estate tax exemption, this can be passed to Wife for her use. Now, upon Wife's death in 2014, she has her own $5 million of federal estate tax exemption as well as the $5 million of federal estate tax exemption that she inherited from Husband, for a total federal estate tax exemption of $10 million. Since her estate is $10 million, her Estate can apply her entire $10 million federal estate tax exemption to insulate her entire estate from federal estate taxes. Thus, portability saves the heirs $2 million in federal estate taxes.

How do these changes affect your existing Proskauer estate planning documents?

Our estate planning documents are drafted to be flexible and, in general, their overall structure remains unaffected by the increased exemption amounts.

There may be instances where you will want to update your documents to reflect changes made by the Act, including the availability of portability. Additionally, if you are a married couple and live in a state with a state estate tax (mostly states in the northeast), there may be provisions that should be added to your documents which could save state estate taxes at the death of the first spouse.

Please do not hesitate to call us so that we can review your documents and make sure that they are up to date and reflect your current wishes.

One Year Later...

This time last year, we found ourselves in a whirlwind of advising clients to maximize transfer tax planning opportunities. We worked to ensure that clients took advantage of what many thought would be a once in a lifetime opportunity to transfer up to $5.12 million free from federal gift and generation-skipping transfer ("GST") taxes. Alas, by the time the dust settled on January 1, 2013, Congress was already hard at work passing the American Taxpayer Relief Act of 2012 ("ATRA"). ATRA made "permanent" the $5 million exemption equivalent amount for estate, gift, and GST tax purposes. This amount is adjusted for inflation in 2013 to $5.25 million and will increase to $5.34 million in 2014. Because of the 2012 dash to "use it or lose it," many clients used significant portions of their exemption in 2012 planning. So what have we been up to this year, and what do we expect for the year to come?

Cleaning Up Prior Planning

Now that there is some certainty in the transfer tax regime, one of the items we have focused on is "cleaning up" some of the lingering transactions from prior years.

Implementation and Reporting of Defined Value Gifts. Because of timing issues associated with obtaining appraisals and the desire to "hit the nail on the head" in making gifts exactly equal to the exemption amount, many clients implemented 2012 gifting through the use of "defined value" or "formula" clauses. These gifts were most commonly made of a client's interests in closely held entities, whether corporations, limited liability companies, or partnerships. This gifting technique was particularly attractive following the 2012 taxpayer victory in Wandry v. Commissioner, notwithstanding the IRS's later non-acquiescence. Although we carefully navigated Wandry and other defined value clause cases in advising clients with respect to these gifts, it is equally important to implement such gifts properly to ensure the benefits of the planning.

When documenting a specific number of shares of stock, partnership interests, or membership interests for transfer on the entity's books and records, the transfer should be caveated appropriately with a footnote or other cross-reference to the defined value or formula clause. Although it is likely acceptable to reflect a transfer of a specific interest on the entity's books and records, it must be crystal clear that the specific interest is derivative of the appraisal, and not of the finally determined value used for federal transfer tax purposes, which ultimately controls the specific interest that is transferred pursuant to the clause. Documenting this transfer as such is particularly important with respect to flow through entities (i.e., subchapter S corporations, partnerships, and limited liability companies) as, generally, distributions are made on a pro rata basis and taxable income is allocated on a pro rata basis.

In addition, when interests are transferred by or to trustees of irrevocable trusts, the trustees will have fiduciary obligations that must be satisfied with respect to such gifts. Translating the formula into a specific interest, even if using the appraised value as an estimate until there is a finally determined value, helps to satisfy the trustees' fiduciary obligations.

Clients Want to "Change" the Terms of the Trust. In the frenzy of signing and funding trusts prior to the end of 2012, many clients may not have had ample time to consider fully all the various provisions in quickly drafted trusts to which they made their 2012 gifts. For example, clients may want to consider different dispositive or fiduciary provisions than what were included in the instruments they signed. Indeed, if a trust was signed and funded toward the end of 2012, many clients may have used a "place holder" trustee to expedite the transaction. A simple "remove and replace" power in the trust instrument may permit flexibility in selecting a successor trustee. However, more significant changes may be in order. Relying on a decanting provision in the trust instrument or under state law can allow the trustee the flexibility to "change" the terms of the trust.

Depending on the terms of the trust instrument or provisions of state law, the "changes" to a trust that can be achieved through a trust decanting can be broad. Under many state statutes, the only changes that cannot be achieved through a trust decanting are the reduction or elimination of fixed income or annuity interests, the disqualification from a marital or charitable deduction, and the addition of trust beneficiaries. To the extent that the trust instrument and its governing law do not permit the trustees to decant the trust, the trustees should explore whether the governing law of the trust can be changed to a more favorable jurisdiction so that the decanting can be implemented. Additionally, clients might consider state statutes that provide for judicial or non-judicial modification or reformation. In so doing, trust beneficiaries must be sensitive to possible transfer tax consequences in the event consent (or even notice) is required.

Planning for Step-Up in Basis. Because of timing constraints and liquidity issues, many clients may have funded irrevocable trusts with low-basis assets. These clients would do well to consider the income tax consequences to the trust beneficiaries as a result of the loss of a step-up in basis at death. Two possible solutions are available for these clients.

First, if the trust contains a power of substitution, or "swap power" (many of the trusts that we drafted at the end of 2012 have these provisions), the client can "swap in" assets of equal value with a higher basis and "swap out" the low-basis assets. In executing this "swap," the trustees must ensure that the assets "swapped in" are equal in value to the assets "swapped out." Not only is this part and parcel to the trustees' fiduciary obligations, it is also necessary to avoid the imputation of any deemed gifts. The best practice is to disclose such "swaps" on a gift tax return.

Second, even if the trust does not contain a "swap power," but is otherwise a grantor trust, the client can purchase assets from the trust. The purchase can even be done with a promissory note. This allows the client to regain the economic benefits of the assets, while still having completed the gift and having an obligation at death that reduces the client's taxable estate. If, in making the gift, the client simply wanted to transfer an amount equal to the exemption, the note can be structured at the applicable federal rate to allow the client the benefit of any future appreciation. If the gift was intended to allow future appreciation to grow outside of the client's estate, then the note can be structured at a higher rate to result in greater appreciation within the trust.

Lack of GST Exemption. Most clients who used their entire exemption in 2012 gifting allocated GST tax exemption to those transfers. This may cause problems for clients who need to continue to rely on annual exclusion gifts to fund life insurance premiums through life insurance trusts. If the policy is owned by an "old and cold" life insurance trust, then funding such trust with annual exclusion gifts may result in a "mixed" GST tax inclusion ratio, as the client will no longer have GST exemption to allocate to the annual exclusion gifts. A "mixed inclusion ratio" means that a trust is partially GST exempt and partially GST non-exempt. Some relief may be available year-by-year because of the inflation adjustment of the exemption. For example, clients who maxed out their GST tax exemptions in 2012 have an additional $130,000 to allocate in 2013 and will have another $90,000 to allocate in 2014. This may go a long way for some clients in preserving the GST tax exempt status of their life insurance trusts.

However, if the additional exemption made available through the inflation adjustment is insufficient, alternatives need to be considered. The most attractive option is likely to make sure that the life insurance policy is owned by the same trust to which the 2012 gifting was made, so that the income from the gift, or a portion of the gift itself, may be used to service the premium payments, thereby preserving the GST tax exempt status of the trust. If the planning was not structured this way from the outset, several options may be available. First, the "old and cold" life insurance trust can be merged into the 2012 gifting trust under the terms of the trust instrument or under state law if such merger is so permitted. Second, the "old and cold" life insurance trust and the 2012 gifting trust can be decanted into a single new trust pursuant to the trust instrument or state decanting statutes. Third, if the prior two options are not available, the "old and cold" life insurance trust can sell the policy to the new trust. It is critical that the purchasing trust be treated as a grantor trust wholly owned by the insured in order to ensure that the transfer falls within the exception to the "transfer for value rules."

Alternatively, clients can consider lending to life insurance trusts so that the trustees can use the loan proceeds to pay the life insurance premiums.

2012 Gifting Results in "Mixed Inclusion Ratios." Because certain clients may have had more gift tax exemption than GST tax exemption remaining, they funded trusts in 2012 that resulted in mixed inclusion ratios. The solution to the tax inefficiencies caused by a mixed inclusion ratio is a qualified severance. A qualified severance is a severance of a trust with a mixed inclusion ratio into two or more separate trusts, so that one of the resulting trusts is wholly exempt and the other is wholly non-exempt. Generally, the severance must occur on a fractional basis and the terms of the new trusts, in the aggregate, must provide for the same succession of interests of beneficiaries as are provided in the original trust.

Reliance on the qualified severance provisions may be a huge relief for clients whose remaining exemption in 2012 exceeded their remaining GST tax exemption (most often on account of allocation to life insurance trusts or allocation upon the expiration of the annuity term of a GRAT). These clients wanted to max out the amount they could give in 2012 at the higher exemption, but had concerns about the long-term consequences of administering mixed inclusion ratio trusts. Thankfully, qualified severances are here to stay as a result of ATRA.

"Zero-Exemption" Planning

After the cleanup is done, there are still plenty of options for clients who exhausted their entire exemption through prior planning. The extra inflation adjustment may add just enough cushion for certain techniques as well.

Sales to Defective Grantor Trust. A sale to a defective grantor trust is the most logical and most powerful technique to implement as a follow-up to 2012 gifting. If the donor's gifts were made to a defective grantor trust, then the "seed" required for a sale to the trust has already been planted. Assuming that the donor transferred $5.12 million to the trust and assuming a 10 percent seed consistent with the generally accepted rule of thumb, a donor could sell over $50 million of assets to a defective grantor trust. If the assets are closely-held business interests and the donor can substantiate a modest 25 percent valuation discount, the donor can sell almost $67 million of assets to the trust. So long as the Obama Administration's proposal to kill defect grantor trusts does not become a reality, sales will remain very much en vogue.

Intrafamily Loans. An intrafamily loan is an often overlooked technique, perhaps given that it does not seem as "sexy" as other techniques. However, this technique should be at the top of most lists. By loaning assets to family members, or, better yet, defective grantor trusts, the spread between the return on investment of the loaned assets and the historically low applicable federal rate passes transfer tax free. It is simple, effective, and risk free. Best of all, intrafamily loans do not result in any taxable gift and, thus, no remaining exemption is required to implement the planning on a tax free basis.

Grantor Retained Annuity Trusts. GRATs remain attractive options for many clients, especially with historically low applicable federal rates. If structured as a "zeroed-out" GRAT, this may be one of the most effective planning techniques for clients who have little or no exemption remaining. Of course, the inability to allocate GST exemption during the GRAT term makes the planning somewhat less attractive. But many clients considering this as a "zero-gift" technique may have little or no GST exemption remaining anyway. Even if the 10 year minimum term as proposed by the Obama Administration becomes reality, GRATs will remain a go-to technique in the coming years.

Charitable Lead Annuity Trusts. Like a "zeroed-out" GRAT, a "zeroed-out" charitable lead annuity trust (CLAT) may be an attractive option for clients who are charitably inclined. Although the annuity payments to charity required to "zero-out" a CLAT may be larger than what a client may typically prefer when the client has some remaining exemption, the ability to pass the remainder free of gift tax can still produce positive results.

Qualified Personal Residence Trusts. A qualified personal residence trust (QPRT) also can be structured in a manner that results in a minimal taxable gift under the right set of circumstances. The taxable gift resulting from a QPRT is a function of the length of the QPRT term. By lengthening the QPRT term, the value of the remainder deceases, and, accordingly, so does the taxable gift.

Conclusion

The whirlwind that was 2012 is now in the history books, but the planning is far from over. We must continue to work to ensure that the plans that were so diligently implemented before the clock struck midnight on December 31, 2012 are properly administered and continue to reflect the client's estate planning objectives. And even for clients who have made gifts equal to or exceeding their exemptions, there are still plenty of highly effective techniques to reduce their transfer tax exposure in the years to come.

Reading the IRS Q&A on Net Investment Income Tax with a Focus on Estates and Trusts

On November 27, 2013, the Internal Revenue Service updated the series of Questions and Answers (the Q&A) explaining the basics of the new 3.8 percent net investment income tax (the NII tax) that it previously released on August 8, 2013. The NII tax, which came into effect on January 1, 2013, is imposed under Section 1411 of the Internal Revenue Code, a new provision added to the Code by Section 1402 of Title X of the Patient Protection and Affordable Care Act. Although the IRS published proposed regulations in December 2012 and final regulations on November 26,2013, the Q&A provides a more concise description of: (1) who must pay NII tax, (2) what's included in NII, and (3) how the tax is reported and paid.

Who Must Pay?

Questions 3-7 of the Q&A explain who's required to pay NII tax. The NII tax is applicable to individual taxpayers with modified adjusted gross income over the following amounts: $250,000 for married taxpayers filing jointly (or a qualifying surviving spouse with one or more dependent children); $125,000 for married taxpayers filing separately; and $200,000 for all other individual taxpayers, including single taxpayers or taxpayers filing as head of household. As noted in Question 3, the threshold amounts aren't indexed for inflation.

Estates and ordinary trusts are subject to the NII tax: if (1) they have undistributed NII, and (2) their adjusted gross income is greater than the dollar amount at which the highest income tax bracket for trusts and estates begins ($11,950 in 2013 and $12,150 in 2014). The NII tax will be equal to 3.8 percent of the lesser of: (1) the undistributed NII for the tax year, or (2) the excess of the gross income over $11,950 (or, in 2014, $12,150). Because most income generated by estates and trusts will count towards NII, affected estates and trusts are likely to experience a 3.8 percent increase in their marginal income tax rates.

In general, the NII tax is applicable only to trusts that are subject to fiduciary income tax under Part I of Subchapter J of Chapter 1 of Subtitle A of the Code. This excludes trusts that aren't classified as "trusts" for income tax purposes, such as business trusts (which are generally taxed as entities), common trust funds, designated settlement funds and other trusts subject to specific taxation regimes. In addition, trusts that are generally exempt from income tax, such as charitable trusts and qualified retirement plan trusts, are exempt from the NII tax. There are special rules for the calculation of NII with respect to charitable remainder trusts and electing small business trusts that own interests in S corporations.

As noted in Question 6 of the Q&A, trusts that are treated as "grantor trusts" for income tax purposes aren't directly subject to the NII tax. Rather, a grantor trust's NII, like all of the trust's income, deductions and credits, will be includible in the computation of the grantor's income tax.

Additionally, Question 6 notes that estates and trusts must only pay NII tax on undistributed net investment income. This is consistent with the fiduciary income tax rules, which allow for deductions of distributable net income that is required to be distributed or otherwise properly paid to beneficiaries. Instead, such income (including any items that may be considered NII) is included in the gross income of the beneficiaries who received distributions.

What's Included in NII?

Questions 8-14 discuss which items are included in NII. As a general rule, NII includes various types of income and gain that are generated by investment activities such as interest, dividends, capital gains, rental and royalty income and non-qualified annuities. In addition, income from businesses involved in trading financial instruments and commodities, as well as income from businesses that are considered "passive activities" with respect to the taxpayer, constitutes NII. As noted in Question 10, capital gains includes gains from the sale of stocks, bonds, mutual funds, investment real estate and interests in partnerships and S corporations.

When considering potential NII tax liability, fiduciaries should keep in mind that the tax is imposed on net investment income. As noted in Question 13, deductions that are properly allocable to investment income are allowable as deductions for computing NII tax liability as well. This may include state and local income taxes properly allocable to items included in NII.

How is NII Tax Reported and Paid?

Questions 15-18 discuss the manner in which NII is reported and NII tax is paid. Individuals, estates, and trusts will use Form 8960 to compute their Net Investment Income Tax. The IRS website contains a link to a draft Form 8960, but the final form has not yet been released.

Individual must attach Form 8960 to, and submit payment of NII tax with, Form 1040. Trusts and estates must do the same on Form 1041. In addition, as noted in Question 16, NII tax is subject to estimated tax provisions. Fiduciaries should adjust their withholdings and estimated tax payments accordingly.

Income Tax Planning Opportunities

Both the nature of the NII tax and the differences between its application to estates, trusts and to individuals provide opportunities for income tax planning. In deciding whether a trust should be created as a grantor trust for income tax purposes, one needs to consider the potential income tax benefits of having certain items of income attributed to the grantor. In some cases, items that would otherwise be considered NII with respect to a trust might be exempt from NII tax with respect to the grantor. For example, income generated in the due course of operating a business in which the grantor is actively engaged may not be subject to NII tax in the hands of the grantor.

Considerations related to the NII tax might also influence the nature and timing of distributions to beneficiaries. Trustees may make distributions to shift income to beneficiaries whose modified adjusted gross income is less than the threshold amount. In addition, there may be advantages to distributing certain types of income producing assets (such as interests in active businesses) to beneficiaries with respect to whom the income generated wouldn't be considered NII.

The NII tax adds another layer to an already complex body of tax provisions that are applicable to estates and trusts. Please contact us if we can be of assistance with these new rules.

Obamacare Medicare Taxes -- Increasing Your 2013 Tax Bill

Holly Magister, for Forbes writes: Several years ago Warren Buffett made his opinion clear about how he felt wealthy Americans should pay more in federal income taxes. Specifically he cited income from investments, which are subject to a lower tax rate. He also held the opinion that it is unfair our tax code provides a tax break on earnings over the Social Security Wage Base Limit ($113,700 in 2013). Wage earners over the limit do not pay Social Security taxes on the excess. 

While Mr. Buffet’s suggestions have yet to be fully adopted by Congress, the need to fund the Affordable Care Act (ACA) mirrors his sentiments and has given rise to two new taxes collectively referred to as the Obamacare Medicare Tax.

I find the use of the term Medicare Tax for the new taxes confusing on several levels. First because Medicare taxes are withheld presently from an employee’s paycheck at the rate of 1.45% plus an employer matched rate of 1.45%, for a total tax rate of 2.9%. Whereas, what is widely referred to as the new Obamacare Medicare Tax is actually a tax on passive investment income and is known as the Net Investment Income Tax (NIIT). The second area of confusion is the new tax’s rate. It is 3.8%, not 2.9%.

To further complicate matters, there is another new tax referred to as the Obamacare Medicare Tax or Medicare Surtax. This one applies to the wages and self-employment earnings of high income taxpayers. This tax is 0.9% and is similar to the NIIT in that it is applied to wages and self-employment income when a taxpayer exceeds certain Modified Adjusted Gross Income thresholds.

To me it seems reasonable to assume the new Obamacare Medicare Tax would equal the current Medicare Tax rate of 2.9% and would be applied to the taxpayers’ passive investment and earned income if they exceed the income thresholds as defined in the new law. However, this is not the case. The two new Obamacare Medicare Taxes total 4.7% instead of 2.9%:  3.8% Tax on Net Investment Income plus 0.9% Tax on Wages and Self-Employment Income equals 4.7%.

If the new taxes were not referred to as Medicare Taxes, I wouldn’t have attempted to make mathematical sense of the new tax rate. However, my nature is to add things up and when I do and they total 4.7% instead of 2.9%, I wonder if I am the only taxpayer confused by the math and fuzzy language?
For these reasons, I personally would prefer to call the two new taxes the Buffett Tax. Nevertheless, for the purposes of this article and Infographic, we’ll stick with its commonly known name: the Obamacare Medicare Tax.

In part one of this two-part Infographic series, the expiring tax credits and tax deductions on December 31st, 2013 were summarized.

In this post, I summarize how the new Obamacare Medicare Taxes may apply to successful entrepreneurs and other taxpayers, and if so what exactly is included in its computation.

 
The New 3.8% Obamacare Medicare Tax May Apply
For successful entrepreneurs and other taxpayers who have Modified Adjusted Gross Income in excess of the “applicable thresholds” defined by the IRS, and have Net Investment Income, according to the definition set forth in the IRS Final Regulations, the 3.8% NIIT will apply when filing their 2013 personal income tax return. The Net Investment Income Tax Regulations were released on November 26th, 2013 giving taxpayers and their advisors very little time to fully understand the impact this new tax will have on the 2013 federal tax returns.

The new NIIT will apply to taxpayers in 2013 who report Net Investment Income on their federal tax return and have Modified Adjusted Gross Income (MAGI) in excess of their respective filing status thresholds:

• Married Filing Separate threshold for NIIT is $125,000.
• Single, Qualifying Widow(er) or Head of Household threshold for NIIT is $200,000.
• Married Filing Jointly threshold for NIIT is $250,000.
It’s important to note that if a taxpayer’s MAGI does not exceed the threshold noted above, they do not need to worry about the new Net Investment Income Tax.
Likewise, a taxpayer without Net Investment Income to report on their 2013 tax return may disregard this new tax altogether.

What is Net Investment Income?
In general terms, the new Net Investment Income Tax (NIIT) applies to income which is passive in nature. Included in the computation of Net Investment Income are the following forms of income:


• Interest, dividends, royalty income, non-qualified annuities and rental income
• Income from businesses trading financial instruments and/or commodities
• Income from Passive Activity Businesses
• Net gains from the sale of stocks bonds and mutual funds
• Capital Gain Distributions from Mutual Funds
• Gain from the Sale of Investment Real Estate and Interests in a Passive Income Business
• Gain from the taxable portion of the Sale of a Personal Residence subject to regular income tax

What is NOT Net Investment Income?
It’s worth clarifying for readers which forms of income are not considered to be Net Investment Income (NII):
• Wages earned and Self-Employment Income
• Income from an Active Trade or Business
• Unemployment Benefits and Alimony Income
• Excluded portion from regular income tax on the Sale of a Personal Residence
• Tax Exempt Interest Income
• Social Security Benefits
• Certain Qualified Pension Plan Distributions

The New 0.9% Obamacare Medicare Surtax May Apply
Taxpayers who are employees and/or have self-employment income with Modified Adjusted Gross Income in excess of the respective filing status thresholds below will be subject to the new 0.9% Medicare Surtax in 2013:

• Married Filing Separate threshold for 0.9% Medicare Tax is $125,000.

• Single, Qualifying Widow(er) or Head of Household threshold for 0.9% Medicare Tax is $200,000.

• Married Filing Jointly threshold for 0.9% Medicare Tax is $250,000.

Tax Planning is Not a DIY Project
The Obamacare Medicare Taxes are new in 2013 so properly planning for them by making adequate tax deposits, if sufficient federal tax has not been withheld by the taxpayer’s employer during 2013, is highly recommended. This is not a Do It Yourself Project! The complexity involved with the new Obamacare Medicare Taxes, particularly with respect to the proper classification of rental, passive and active income precludes most successful entrepreneurs and other taxpayers from planning for and filing their own income tax returns.

Furthermore, the additional taxes imposed by Obamacare give rise to the need for entrepreneurs to revisit with their advisors matters related to their business entity structure, their various entity and personal income and tax liabilities and last, but not least, their net cash flows in order to sustain a viable business in the future.

Optimizing tax loss harvesting / Crucial “blocking and tackling” for financial advisers

Chad Smith for Investment News writes:  Thanks to strong equity market returns over the past two years, investors have made significant progress in rebuilding their portfolios. Many clients, however, remain on edge as they wait for the “other shoe” to drop. Contrary to the first-blush reaction of many, this other shoe isn't the potential of continued gridlock in future months around our nation's debt ceiling — it's the impact of an ever-more-complex tax code.

Last January, the top capital gains tax rate increased from 15% to 20%, while a 3.8% investment income surtax kicked in for many investors as well. Those are just the federal taxes — depending on where they live, many clients are preparing themselves for another significant tax hit at the state level as well.

More than ever before, financial advisers possessing or having ready access to professional tax expertise can add value for their clients. This unique quality allows advisers to distinguish themselves by providing guidance that integrates both tax and investment solutions. For one clear example of this, look no further than the basic practice of tax loss harvesting. 

No doubt, the vast majority of advisers understand the concept that investors should look to sell the losers in their portfolio at the end of the year in order to offset gains from winners. In 2013, as many investors' portfolios have shifted away from their asset allocation targets due to gains in equity assets and losses in fixed income, harvesting losses in a careful and strategic manner will be especially crucial.

Without access to tax expertise, however, even this fundamental practice can be difficult for advisers to implement. Estimating capital gains and losses for every asset in each non-qualified account, for each client, and then executing the proper strategy to lock in the most favorable tax treatment is a time-consuming and complex process. For both advisers and their clients, however, the effort is clearly worth it: no investor can afford to lose out on tax savings that may amount to 30% or more of their capital gains when state and federal taxes are considered.

Capital gains are taxed differently depending on the holding period of your investment. The holding period is how long you have held an investment. A short-term holding period is typically one year or less, and a long-term holding period is usually more than one year. 

Short-term capital gains are taxed at ordinary income tax rates. In 2013, this ranged from 10% to 39.6%. The tax on long-term capital gains is typically less than ordinary tax rates. The long-term capital gains tax is either zero percent, 15% or 20% depending on your marginal tax bracket.
For advisers seeking to maximize tax benefits for their clients by harvesting losses in 2013, we suggest the following best practices:

1. Look for opportunities to maintain each client's overall investment strategy and asset allocation targets by substituting exchange-traded funds or indexed funds with similar objectives and holdings for the winners and losers being sold.

Advisers and clients often find themselves stymied in executing tax loss harvesting plans because they believe strongly in a given fund manager, or because selling a fund would reduce the client's exposure to certain assets or sectors. By shifting client assets into funds that are similar to those being sold, advisers can continue to participate in managers' strategies, while often maintaining very similar overall holdings.

In the ETF world, substituting one ETF for another without disrupting a client's strategies or asset allocations is even more straightforward.

2. Be aware of the wash sale rule, an Internal Revenue Service rule that prohibits a taxpayer from claiming a loss on the sale or trade of a security in a wash sale. The rule defines a wash sale as one that occurs when an individual sells or trades a security at a loss and within 30 days before or after this sale, buys a “substantially identical” stock or security, or acquires a contract or option to do so. A wash sale also results if an individual sells a security, and the spouse or a company controlled by the individual buys a substantially equivalent security.

In order to ensure that clients recognize losses of the same magnitude as their gains and achieve the strongest tax deferral outcomes in 2013, there is simply no substitute for a manual review process performed by an attentive adviser. For investors who will experience lower income next year, the right answer may be to hold off on selling 2013 winners altogether.

3. For clients with significant assets but whose income puts them in the 15% ordinary income tax bracket (below $72,500 for married taxpayers filing jointly or $36,250 for single filers), consider taking winners off the table even if the client does not have offsetting losses elsewhere. Taxpayers in the 15% bracket can sell appreciated stock at a 0% federal capital gains rate. Selling now may be the best way for such investors to ensure they benefit from the current tax treatment. Moreover, these clients can establish a stepped-up basis in similar assets by shifting their holdings from current winners into similar funds as mentioned above.
As we're seeing more each year, the rising complexity of the tax code and ongoing potential volatility in the capital markets are driving investors — particularly in the high-net-worth segment — to recognize the inherent value that comes from combining investment advice with in-depth guidance on the tax front. 

No matter how well a client's investment strategy performs, no investor can afford to lose out on the incremental returns that come from a properly-executed tax loss harvesting process. By committing the time to implement the best practices listed above, advisers can ensure that their clients are well-positioned to weather changes to the tax code both this year and in the future.

Plan now to get full benefit of saver's credit

MinuteMan NewsCenter writes: Low- and moderate-income workers can take steps now to save for retirement and earn a special tax credit in 2013 and the years ahead, according to the Internal Revenue Service.

The saver’s credit helps offset part of the first $2,000 workers voluntarily contribute to IRAs and to 401(k) plans and similar workplace retirement programs. Also known as the retirement savings contributions credit, the saver’s credit is available in addition to any other tax savings that apply.

Eligible workers still have time to make qualifying retirement contributions and get the saver’s credit on their 2013 tax return. People have until April 15, 2014, to set up a new individual retirement arrangement or add money to an existing IRA for 2013. However, elective deferrals (contributions) must be made by the end of the year to a 401(k) plan or similar workplace program, such as a 403(b) plan for employees of public schools and certain tax-exempt organizations, a governmental 457 plan for state or local government employees, and the Thrift Savings Plan for federal employees. Employees who are unable to set aside money for this year may want to schedule their 2014 contributions soon so their employer can begin withholding them in January.

The saver’s credit can be claimed by:

Married couples filing jointly with incomes up to $59,000 in 2013 or $60,000 in 2014;

Heads of Household with incomes up to $44,250 in 2013 or $45,000 in 2014; and

Married individuals filing separately and singles with incomes up to $29,500 in 2013 or $30,000 in 2014.

Like other tax credits, the saver’s credit can increase a taxpayer’s refund or reduce the tax owed. Though the maximum saver’s credit is $1,000, $2,000 for married couples, the IRS cautioned that it is often much less and, due in part to the impact of other deductions and credits, may, in fact, be zero for some taxpayers.

A taxpayer’s credit amount is based on his or her filing status, adjusted gross income, tax liability and amount contributed to qualifying retirement programs. Form 8880 is used to claim the saver’s credit, and its instructions have details on figuring the credit correctly.

In tax-year 2011, the most recent year for which complete figures are available, saver’s credits totaling just over $1.1 billion were claimed on nearly 6.4 million individual income tax returns. Saver’s credits claimed on these returns averaged $215 for joint filers, $166 for heads of household and $128 for single filers.

The saver’s credit supplements other tax benefits available to people who set money aside for retirement. For example, most workers may deduct their contributions to a traditional IRA. Though Roth IRA contributions are not deductible, qualifying withdrawals, usually after retirement, are tax-free. Normally, contributions to 401(k) and similar workplace plans are not taxed until withdrawn.

Other special rules that apply to the saver’s credit include the following:

Eligible taxpayers must be at least 18 years of age.

Anyone claimed as a dependent on someone else’s return cannot take the credit.

A student cannot take the credit. A person enrolled as a full-time student during any part of 5 calendar months during the year is considered a student.

Certain retirement plan distributions reduce the contribution amount used to figure the credit. For 2013, this rule applies to distributions received after 2010 and before the due date, including extensions, of the 2013 return. Form 8880 and its instructions have details on making this computation.

Begun in 2002 as a temporary provision, the saver’s credit was made a permanent part of the tax code in legislation enacted in 2006.

To help preserve the value of the credit, income limits are now adjusted annually to keep pace with inflation. More information about the credit is on IRS.gov.

A Solution To The IRA Required Minimum Distribution Blues

Ashlea Ebeling for Forbes writes: Four out of ten people who are supposed to take withdrawals from their Individual Retirement Accounts for 2013 had yet to do so as of Dec. 6, putting them in danger of facing a tax penalty, according to Fidelity Investments. If you fail to take a required minimum distribution (RMD) from an IRA, you risk owing a penalty calculated as 50% of the amount you should have taken out but failed to. So it’s good news that there’s a handy solution to prevent this: putting your IRA distributions on auto-pilot.

Fidelity has been promoting the idea of enrolling in automatic withdrawals to its clients, and for tax year 2013 almost half (47%) of its 500,000 Individual Retirement Account owners who are required to take money out were signed up, a 167% increase over tax year 2012. Still 42% hadn’t taken any money out as of Dec. 6, suggesting a lot of taxpayers are dawdling—or possibly making a big tax mistake.


A quick recap of the basic rules: IRA owners must normally begin taking annual RMDs after they turn 70 and a half from their own traditional IRAs or IRAs inherited from a spouse, although not from their Roth accounts. Non-spousal IRA heirs of any age must take RMDs from both traditional and Roth accounts. The amount you must take out is calculated based on your life expectancy and the balance in your IRAs the end of the prior year.

There are special rules: for folks who turn 70 and a half, they typically have until April 1 of the following year to take their first distribution. Another trap: there is an RMD required in the year of death, if the deceased is over 70 and a half.

Some IRA owners might be waiting until year-end simply to get every last day out of the tax-deferred (or tax-free if it’s a Roth) compounding that’s the appeal of these accounts.

Another tax-wise year-end IRA strategy if you’re 70 and a half or older is to give gifts to charities directly from your IRA; these gifts count toward your RMD. The law that allows this, the IRA-Charitable Rollover law, expires on Dec. 31, 2013 (it’s one of the tax extenders Congress is leaving in limbo). It lets you direct the custodian of your pretax IRA to transfer up to $100,000 per year to a public charity without having to count that distribution in your income. In return, you’ll forego the charitable income tax deduction. Still this strategy can leave you ahead whether or not you normally itemize deductions or not. But act fast—the charity must cash the check by Dec. 31 for the distribution to count towards your 2013 RMD.

A couple of other IRA-RMD-related items on the legislative front to watch out for: President Barrack Obama has proposed eliminating RMDs for IRAs worth $75,000 or less, and making non-spouse beneficiaries of inherited IRAs deplete the accounts within five years of inheriting them.

Fidelity has answers to commonly asked RMD questions, including the mechanics of giving your RMD to charity, here.