Harnessing the Power of Trusts to Help Your Clients and Grow Your Practice

The Firm focuses on Simple & Complex Estate Planning, Special Needs Planning, Elder & Medicaid Law, Probate Law, Guardianships, Conservatorships, LLCs, S-Corps., FLPs, 501(c)(3) Corps., Mergers & Acquisitions, Trademarks, and Tax & Litigation matters regarding the same.

Trust planning is an area where the work of attorneys and financial advisors interfaces. It can be a powerful and effective tool in helping both disciplines to grow their practices.

In this issue of The Wealth Counselor, we will look at how estate planning is changing after TRUIRJCA 2010, what clients want in estate planning, and how incorporating trust planning will benefit clients, their families and the professional advisors who serve them.

Is There a Crisis in Estate Planning?
The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRUIRJCA 2010), which the President signed on December 17, 2010, has had a major impact on estate planning.

TRUIRJCA 2010 increased the applicable exclusion amount to $5 million, made it portable for the first time, adjusts it for inflation starting after 2011, set the maximum estate tax rate at 35%, and restored the gift tax exemption at $5 million – but all only through 2012.

The result is that most families don’t have an estate tax problem, at least not for now. Few families have net estates of more than $5 million; even fewer married couples have combined net estates of more than $10 million. This is causing a crisis for professionals who have promoted estate tax avoidance as the primary reason to do estate planning. Insurance advisors who for years have sold policies to fund estate tax liabilities are now finding fewer buyers for their products. Lawyers who have always sold planning as a way to pass wealth on instead of paying it to Uncle Sam are floundering.

The Danger and Opportunity Before Us
The danger is real. Prospective clients may think there is no need for them to plan because they are exempt from the estate tax, at least for now. They may be lulled into a false confidence that the estate tax does not affect them, when in reality it may in the near future. They may be forgetting that the current tax law is only a two-year deal that Congress made, and the law will change in 2013, or possibly sooner. Or they may be foolishly using “waiting to see what the Congress will do” as an excuse to postpone their planning.

The opportunity is real, too. As estate planners, we need to give up the “addiction” of relying on the estate tax as a primary business driver. We need to re-think our approach and remember why we became estate planners in the first place.

While some may view the new tax law as an end to estate planning as we know it, we can also see it as an opportunity to finally focus on what our clients really want.

What Clients Really Want
Essentially, clients want the same things we all want:

For Themselves — Protection and Control. They want control over their assets and health care decisions. They want financial security. They want to be protected from the risks of life, which include lawsuits, disability and the cost of long-term care. Most have some philanthropic goals.

For Their Surviving Spouse — Financial Security. They want to know that their hard-earned assets will not pass to a new spouse. And they want the surviving spouse protected from taxes, primarily from income tax.

For Their Children and Grandchildren — An Education and Financial Security, including Asset Protection from Immaturity, Divorce and Lawsuits. A big motivator for planning can be protecting assets from gift, estate and income taxes for as long as possible, even for several generations. They want their family members to live successful lives that include a work ethic, integrity, faith, and appreciation and respect for family members. Above all, they want their family members to love each other, spend time together and avoid conflict. They do not want them to be harmed by the wealth that is left to them. This is often far more important than tax planning.

For Their Business or Farm — Attract and keep quality talent and have protection from frivolous lawsuits. They want their business or farm to pass to family members who desire to own and operate it, while treating non-participating family members fairly, or they want to sell it to employees or outsiders.

What We Can Provide
These client needs are timeless. No Congress can ever legislate these needs away. Our solutions are also timeless. We need to build our practices around these needs and solutions, instead of having estate tax avoidance be the main need and motivator.

Planning Tip: Think about why you do what you do. People don’t buy what you sell; they buy why you sell it. If you sell a product, they can always find someone who will sell it for less. If your “why” is protecting your clients, their families, their farm or business, etc., they will see that you are putting these needs first.

Five Ideas that Will Get Results…for You and Your Client
The following planning suggestions will work now for most of your clients, and can help you get on the right track in your practice.

Idea #1: Teamwork Produces Better Work
Use a two- to four-meeting process involving other professionals. This will allow you to provide more thoughtful solutions to your client’s needs. It will also allow time for the team of advisors to meet without the client, discuss the situation and possible solutions, and make sure all advisors are on board so that the client hears a consistent message from each advisor. Also, having a team approach over time allows the client to see that recommended financial products (life insurance, annuities, trusts, long-term care insurance, etc.) are part of the total planning solution and not a sales pitch.

Planning Tip: Ask for the name of any other persons the client will consult (friend, CPA, etc.) in making a decision, and get permission to talk with them before making recommendations to the client. Then have those talks and assure all will endorse the plan ahead of time. It will take more time on the front end, but will keep things from being sabotaged by someone you were not even aware of.

Idea #2: Use the $5 Million Gift Tax Exemption Now
We may only have this for a couple of years, but it could disappear even sooner than 2013 as Congress begins to focus on how to raise revenue and cut spending. Discounts may also go away. You can legitimately create a sense of urgency to use this exemption to start moving appreciation out of a potentially taxable estate.

Use the $5 million gift tax exemption to fund a large life insurance policy in an irrevocable life insurance trust (ILIT) that can build up cash value for a supplemental retirement fund or provide an alternative financial investment. A second-to-die policy to pre-fund estate taxes could also be purchased. The $5 million exemption can also be used to fund a GRAT or seed an IDGT sale using LP, LLC or C- or S-corp stock.

Planning Tip: There are two relatively easy ways to give clients access to insurance owned by an ILIT. First, set up the ILIT so that the trustee can make withdrawals or loans from the cash value of the policy and lend the proceeds to the grantor/insured. It can be an interest-only loan during the grantor’s lifetime, with no additional income tax due; at the grantor’s death, the loan can become a debt of the estate. (It must be a credible loan, fully documented, and the grantor must have the means to make the interest payments.) Alternatively, the distributions can be made to the insured’s spouse, on the assumption that they will stay married and the spouse will “share” the proceeds with the insured.

Planning Tip: Remember that both GRATs and IDGT sales need insurance protection, and insurance is easier to fund with a $5 million gift exemption ($10 million if married). You may even be able to avoid Crummey gifts altogether.

Idea #3: Encourage Clients to Leave Assets in Trust
This is good for your clients, and for your clients’ children and grandchildren. Assets kept in a trust are protected from predators (including the surviving spouse’s next spouse), irresponsible spending, creditors, divorce, etc. Ask your client: “If you could protect the assets, why would you not?”

This is also good for you and for your team of advisors, as it keeps the assets under professional management and establishes a relationship with the next generation. This is an excellent way to protect the financial advisors’ book of business against a very real threat.

Idea #4: Think Differently about Your Client’s IRA and Other Tax Qualified Plans
Most clients want to maximize the stretch out on an IRA, but don’t know how to do it. There’s a way to maximize stretch out, provide long-term divorce and lawsuit protection, and create a large life insurance sale. And it will apply to many families with “average” sized estates and IRAs.

Step 1: Leave the IRA to a stand-alone IRA trust for younger generation family members (children or grandchildren). This will provide the maximum stretch out and protection from divorce and/or creditors. An outside trustee can prevent an early cash out and protect the intended stretch out.

Step 2: Use the required minimum distributions to purchase life insurance on the IRA account holder in an ILIT for the benefit of the surviving spouse. When the account holder dies, the surviving spouse will have lifetime access to the proceeds in the ILIT, tax-free. This can be a much better deal for the surviving spouse than becoming the successor to the IRA. The ILIT design provides for successor beneficiaries if the spouse dies first.

Planning Tip: To make the benefits clear for your client, run projections with the spouse as beneficiary of the IRA and a child/grandchild as the beneficiary. Remind your client that distributions from the IRA will be taxable, while the proceeds from the life insurance in the ILIT will be tax-free.

Planning Tip: For those who are charitably inclined, make a charity or church the beneficiary of the IRA; it will receive the proceeds tax-free. Again, use the required minimum distributions to purchase life insurance on the IRA account holder in an ILIT for the benefit of the surviving spouse.

Idea #5: Use Trusts to Help Clients Create a Non-Financial Legacy
Creating a non-financial legacy helps your clients become more connected to the estate planning process and empowers them. Have them write their motivations for the planning and explain discretionary guidelines. If there is heirloom property that is sentimental or historical, they can provide a handwritten note with a story or significance of the item(s).

Planning Tip: Arrange for family meetings after the trust has been signed. You can have them in person for those who live in the area and/or via Skype for out-of-towners. Talk about the planning that has been done and why. This is good for the beneficiaries, as it brings them into the process and helps them understand the motivations, the planning, and the intended results. It also gives the advisors opportunities to meet and become familiar with the next generation.

Conclusion
While TRUIRJCA 2010 has provided us with challenges and has forced us to re-think our approach to estate planning, it has also freed us to be able to do the estate planning that our clients really want without regard to the need for estate tax avoidance. Trust planning remains an integral and valuable part of estate planning, and is beneficial for the client and the professional team of advisors.

Working with Charities for Fun and Profit

Developing alliances between non-charitable advisors (attorneys, CPAs and financial advisors) and advisors to charities (e.g., development officers for non-profit organizations) can provide better service to the team’s clients, make fundraising more effective for the charitable advisors, and thus be beneficial for all concerned.In this issue of The Wealth Counselor, instead of focusing on the technical side of charitable planning (tax and estate planning), we will take a look at the marketing side. We will explore the various forms of fundraising, what fundraisers do for charities, how they are compensated, how they can become part of the estate planning team, and how working together will benefit all involved, professionals and clients alike. Fundraising Overview Fundraising, or the process of soliciting and gathering contributions, such as money or other assets and resources by requesting donations from individuals, businesses, charitable foundations or governmental agencies, is multi-faceted. Its major divisions are annual giving, capital campaigns, major gifts, and deferred (or “planned”) giving. Annual Giving Annual giving focuses on donor acquisition, repeating the gift and upgrading the gift. Most first gifts are small, but annual giving creates the habit of regular giving and, typically, increasing gift size over time. Direct mail solicitations, telemarketing, e-solicitations and special events are most often the methods used to increase annual giving. The ultimate goal of annual giving is lead generation for the other categories of fundraising. Capital Campaigns Capital campaigns are the most common way charities raise the funds needed for special large projects, such as a new building or a permanent endowment. A capital campaign is an intensive, time-limited effort seeking a larger than usual sum of money from the charity’s perspective. Most charities consider hiring an outside consulting firm for a capital campaign rather than hiring or using internal staff. Frequently the outside consultant will guide the existing staff. Major Gifts Unlike annual gifts, which are typically made with cash, major gifts are often made in the form of publicly traded stock, bonds or other negotiable financial assets and, in some cases, real estate and valuable personal property, like art. Each charity establishes its own threshold for what is considered a “major” gift. For a religious denomination, it might be $25,000 or more, whereas a small local charity might set threshold at $1,000. Typically, making a “major” gift entitles the donor to special benefits, such as membership in a giving society (i.e., “Circle of Friends”), recognition in the charity’s publications, or ticket priority for charity events. Deferred (“Planned Giving”) Gifts Deferred gifts are gifts that a donor establishes now for the charity to receive at a future date. Most attorneys, CPAs and financial advisors are familiar with these. In some cases, the donor will receive income and tax benefits during his or her lifetime. Most are complicated and require planning; hence, the term “planned giving.” Typical deferred gifts include Will bequests, post-death revocable living trust distributions, charitable remainder trusts, gift annuities, charity-owned life insurance, and pooled income funds. Although not completely “deferred” (the charity receives a benefit starting in the first year), most planners include charitable lead trusts in the category of deferred gifts. Grants Charities today also sometimes raise money by obtaining grants from individual or corporate private foundations or government agencies. Applying for such grants may be the assigned responsibility of a staff member or outside consultant. What Charities Do with the Money They Raise Charities are just like everybody else. They do two things with the money they get – spend it or save it for future use. Some contributions will be unrestricted and thus available to be used immediately for day-to-day expenses and charitable functions. Many charities also have an endowment fund in which gifts are set aside and held in a special fund to earn income that is used by the charity for general or special charitable purposes. Major gifts and deferred gifts other than for an identified purpose, e.g., a new building, typically go into the charity’s endowment fund. The size of a charity’s endowment fund is often used as a measure of its fundraising and overall success. Endowment funds are often divided into sub-funds to accommodate major contributors who wish to have their gift earmarked for a special purpose, such as scholarships. How Charities Organize Their Fundraising Efforts Many charities have at least one employee whose primary responsibility is fundraising. In smaller charities, a development officer may handle all of the facets of fundraising. Larger charities may have multiple fundraising staff members who are assigned to different fund raising functions within the charity’s office. For example, one may be assigned specifically to developing deferred gifts. How Development Officers Are Compensated Development officers are paid a salary; it is unethical for them to receive a commission. Most are evaluated by their success in closing charitable gifts on an annual basis. Deferred giving officers are evaluated not on actual gifts received, but on expectancies, as they have no control over when a donor will die and thus when the gift will “mature.” How You Can Work Together Development officers and other wealth planning professionals can work together primarily in the area of deferred giving and sometimes with major gifts, especially when gifts of property (real estate, stocks, etc.) are involved. For example, an attorney may be needed to draft the documents, a CPA for compliance and tax issues, and a financial advisor for a life insurance policy or securities transfers. All should be involved in the process as needed to make sure the gift makes sense for and provides the greatest benefit to their client, the donor. What the Development Officer Can Bring to the Team When a client wants to support a charity with a deferred gift, it makes sense to bring the charity’s development officer onto the estate planning team. Some of the benefits he/she can bring to the process include: Knowledge of the charity’s needs and goals; Making sure the gift is used the right way; Hearing and responding to the donor’s desires; A general knowledge of planned giving. Generally speaking, other advisors should not feel threatened by bringing a development officer onboard, as they won’t go against investment advice, provide tax advice, or draft the needed documents. A development officer, however, will be a dedicated member of the team and can be valuable in helping to define the donor’s desires and goals and align them with the charity’s needs and goals. For example, a donor may be thinking he wants his gift to be used for scholarships, but the development officer, who knows that the scholarship fund has plenty of money, may be able to direct the gift toward a building that needs immediate repairs. A Source of New Business for You The client conversation that leads to a major or deferred charitable gift can start with either the planner or with the charity, and both are in the position to bring in other professionals to help with the process. Occasionally a development officer will need to refer donors to attorneys, CPAs and financial advisors in order to complete gifts, and will generally give the donor two to three names from which to choose. A development officer will want to refer his or her donor to professionals who are reliable, have experience in planned giving, will be responsive and are in relatively close proximity to the client. It helps if the professional also personally has charitable intent, which gives him or her valuable insight into what a client/donor wants to accomplish. A Source of New Business for the Charity Your estate planning clients are also prospects for charitable giving, and they can be a source of additional business for you and for charities. Your clients and prospects generally of age 50 and older are the same audience the charity wants to reach. Make it a habit to ask if the client or prospect has any desire to support a charitable cause, either now or with a gift after death, and if so which one. Doing so can only enhance your status as the trusted, knowledgeable advisor. Include a question or two on your intake form or ask in your initial interview. When you get a positive response, take the opportunity to bring the development officer into the planning process. Cultivating Development Officers as Referral Sources The best way to meet development officers and have them become referral sources for you is old-fashioned networking. Here are some suggestions to help you get started. Networking Tip #1: Get to know the nonprofits in your area and learn about the resources and services they offer to the community. If your client has charitable desires, it would be very helpful if you already know which organizations would fit well with your client’s intentions and would benefit from your client’s gift. Networking Tip #2: Local and regional planned giving councils have regular meetings with guest speakers. You can join, attend, and even offer to speak at these. Regular attendance will yield the best results. Networking Tip #3: Some national organizations (including The Advisors Forum and WealthCounsel) provide monthly webinars. You could host them at your office and invite local development officers, as well as other professionals with whom you would like to work. Networking Tip #4: Ask other professionals with whom you already work if they know any development officers in your area. Ask for an introduction and/or a lunch meeting. Networking Tip #5: Cold calling. Look up nonprofits in your area, then call the planned giving or fundraising office and explain that you would like to meet the development officer. It’s not as good as a personal introduction, but it will get you noticed. Networking Tip #6: Some nonprofits host their own “Get to Know Us” educational seminars as a way to attract potential volunteers and donors. Attending one is a great way to show your interest, learn about the nonprofit first-hand and meet the development officers. Networking Tip #7: Offer to provide free seminars for the nonprofit’s donors (and potential donors) on estate planning, planned giving or other current financial planning topic. It’s a great way to find new leads for the nonprofit and for you. Repeating seminars at the same time and location will make it easy for attendees to bring or refer others. Conclusion Developing alliances between attorneys, CPAs, financial advisors and development officers for non-profit organizations is an excellent way to expand your networking opportunities, become more aware of the services and resources available in your community, and generate new business. But most importantly, it will feel good to help your clients and charities in a way that is beneficial to both.

Income Tax Planning Concepts in Estate Planning

Estate planning sometimes has income tax effects. All advisors, therefore, should be at least aware of some basics of income tax planning to best serve their clients. In this issue of The Wealth Counselor, we will examine some of the basics of income tax planning and some of the techniques used in estate tax planning that have income tax impacts. The Goals of Income Tax Planning The taxpayer’s goal is generally to pay the least amount of income taxes they are legally obligated to pay at the latest possible date. Income tax planning is done to help the client get as close to those goals as the law allows. Typically, the amount of tax due is reduced by having the income be in a class that has favorable treatment. Favorable rate treatment is granted to long-term capital gains and qualified corporate dividends. Some income is excluded from taxation altogether, such as interest paid by state and local governments, certain gain realized on the sale of the taxpayer’s residence, and certain income earned while not living in the United States. The last two are subject to limiting rules and so not always available. Income tax liability usually arises when an asset changes hands other than by gift or inheritance. However, the tax liability can sometimes be postponed. Examples are certain like-kind exchange transactions and certain installment sales. Sometimes, the fact of an asset changing hands is ignored for income tax purposes because the tax laws treat the transferring party and the transferee as the same taxpayer. Basic Estate Planning Has No Income Tax Impact Neither a Will nor a revocable living trust changes a client’s income taxes. A Will only takes effect when the client dies and a revocable living trust is classified by the IRS as a grantor trust. Grantor trusts are disregarded for income tax purposes. Advanced Estate Planning Can and Often Does Have Income Tax Implications Advanced estate planning, on the other hand, often involves income tax considerations. Advanced planning involves creation of trusts and/or entities. Sometimes, advanced estate planning is used to reduce income taxes by shifting income from a taxpayer in a high bracket to a taxpayer in a lower bracket. Irrevocable trusts are often used for this purpose when the “kiddie tax” does not apply. The “kiddie tax,” when applicable, imposes the parent’s tax rate to the income of the taxpayer’s child who is under age 24. For this donor to donee income tax liability shift to occur, the trust cannot be a grantor trust with respect to the donor. On the other hand, if the trust is a grantor trust, the donor’s paying the income tax on the trust’s income is not an additional gift. Thus not shifting the tax responsibility can be used to transfer additional wealth to children and grandchildren without using the donor’s gift tax exemption. When an asset is sold, the tax is determined by the amount of gain realized. Gain is generally the difference between the net proceeds of the sale and the taxpayer’s basis in the asset. If the taxpayer receives the asset as a gift, the taxpayer’s basis is the previous owner’s basis plus any subsequent investment by the taxpayer. If the taxpayer received the gift as an inheritance, the basis is the asset’s value at the death of the prior owner plus any subsequent investment by the taxpayer. Advanced estate planning, therefore, weighs the estate and gift tax avoided against the increased capital gain that would be due on the recipient’s sale of a gifted asset as opposed to an inherited asset. Some advanced estate planning involves charities. Trusts with charity and non-charity beneficiaries all have income tax effects. Such trusts are characterized as charitable lead trusts (CLTs) if the charity beneficiaries take before the non-charity beneficiaries and charitable remainder trusts (CRTs) if the charity beneficiaries get what is left over after payment to the non-charity beneficiaries. Both CLTs and CRTs can be grantor trusts or non-grantor trusts, depending on what the client is trying to achieve. Advanced planning with income tax aspects also includes: Investing in assets that produce tax-free income; Converting ordinary income into capital gain income; Defering income for the maximum period of time; Accelerating deductions to the earliest possible year; Taking maximum advantage of depreciation rules; Taking maximum advantage of income exclusion rules; Avoiding tax-inefficient business structures; Structuring transactions to include some or all of the above. Deciding which of these techniques should be used in a particular case requires advanced estate planning experience and probably accounting analysis. It is, however, important for every advisor to be at least aware that they exist so that the appropriate team member can be called on when needed. Planning Tip: Remember, there is nothing illegal or improper about rearranging our clients’ business affairs to take maximum advantage of all lawful strategies to reduce taxes. Taxation of Corporations, Limited Liability Companies, Partnerships, and Non-Grantor Trusts Most corporations, limited liability companies (LLCs), and all partnerships, and non-grantor trusts are taxed differently than individuals. An exception is the LLC owned by an individual or the partnership or LLC owned 100% by a married couple. They will be disregarded for income tax purposes unless the taxpayer owner(s) elect otherwise. Partnerships, for example, are not taxed at all. They report income and deductions, but the taxes are paid by the partners individually. Some corporations and LLCs are eligible to elect to be taxed under Subchapter S of the Internal Revenue Code’s Chapter 1. They are called S-corporations, and they are treated for income tax purposes very much like partnerships – as pass-through entities. Corporations that do not elect or are not eligible for Subchapter S treatment are taxed as separate taxpayers under Subchapter C. They are called C-corporations. LLCs can elect to be taxed as corporations, otherwise they are taxed as partnerships or are disregarded. Some are eligible to be taxed as Subchapter S corporations. Partnerships and LLCs that are taxed as partnerships, have special allocation rules. S-corporation taxation is available only if a number of qualification conditions are met. Some trusts, for example, are not qualified to be Subchapter S owners. Entities in which they own interests, therefore, are ineligible for Subchapter S tax treatment. And with corporations that are not Subchapter S corporations, there are adverse taxation, liquidation and distribution of property issues. Some Specific Income Tax Planning Techniques Home Sale Exclusion Many clients will be able to take advantage of the limited exclusion of gain on the sale of a personal residence. It allows a taxpayer to exclude from income up to $250,000 ($500,000 if filing jointly) of gain, providing the property sold has been the owner’s primary residence for two out of the five years preceding the date of sale. This exclusion is also available for residences owned in revocable living trusts and certain irrevocable trusts, including defective grantor trusts. Planning Tip: Many clients have more than one residence. With planning and a responsive market, a client can use this exclusion every two years to sell multiple properties. For example, sell the principal residence first. Then move into the vacation home, make it the principal residence for two years, then sell it. Converting Income Taxable Assets into Non-Taxable Assets IRAs have built-in income taxes. Plus, they are includible in the owner’s estate as income in respect of a decedent (IRD). Distributions from an inherited IRA are also taxed when received by the beneficiary (although the beneficiary receives an itemized deduction for estate taxes paid on that income). In taxable estates, the net result is that a $1 million IRA is often only worth about $250,000 net to the beneficiary. There are several solutions to this dilemma. Some are: Solution #1: Stretch out the inherited IRA as long as possible to offset the double tax. The longer tax-deferred growth will allow it to earn back some of the amount paid in estate taxes. Naming a young beneficiary will provide the maximum stretch out, allowing for more growth over a longer period of time. To make sure this happens, consider a special-purpose trust designed to receive and stretch inherited retirement plan benefits. Solution #2: Convert the IRA to a Roth IRA. It may make sense to convert and pay the tax now if the IRA assets are expected to increase substantially over the next few years. As with a regular IRA, naming a young beneficiary will provide the maximum stretch out, allowing for more tax-free growth over a longer period of time. Solution #3: Liquidate the IRA now and pay income tax at the current rates. Then gift the net proceeds to an irrevocable life insurance trust (ILIT) where the trustee can use the money to purchase life insurance. This will work well in 2011 and 2012 when the gift tax exemption is $5 million. Using this approach, a $1 million taxable IRA could be converted to over $1 million in tax-free assets for multiple generations. C-Corporations A C-corporation is taxed at a maximum rate of 35%, but, unlike individuals, it has no preferential capital gains rate. Thus, while capital gain income to an individual is taxed at a maximum of 15%, capital gains realized by a C-corporation are taxed at up to 35%. Then, when a C-corporation distributes a dividend to its shareholders, the dividend is taxed at up to 15% on the shareholder’s return – thus creating double taxation on the same income. Even worse, if a C-corporation distributes appreciated assets to its shareholders, a deemed sale will have occurred at the corporate level, regardless of whether the corporation has any cash to pay the tax. S-Corporations An S-corporation is a pass-through entity so there is only one level of tax. Grantor trusts, including revocable living trusts, can be S-corporation shareholders. An irrevocable trust can also be designed so that it is eligible to be an S-corporation shareholder. Getting Out of the C-Corporation Trap Many clients form corporations and elect C-corporation taxation unaware of the problems it can cause in the future because a C-corporation is tax-inefficient. Often the issue only surfaces when there is a real need to get out of the election. Liquidating the C-corporation and re-forming as an LLC (taxed as a partnership) will trigger capital gain on appreciated assets owned by the C-corporation, and shareholders will recognize gain on the receipt of corporate assets. This is not a viable solution unless assets are not appreciated and shareholders have unused capital losses. A better solution is to liquidate the C-corporation, re-form as an LLC, and make the election to be taxed as an S-corporation. This will eventually eliminate the double taxation. However, a 10-year rule applies, so it is best to get the process started as soon as the problem is detected because any disposition of corporate assets within this 10-year period will result in some double taxation. Deferring Income Recognition Any time a client can defer taxes, it is wise to do so unless the tax rate increases. The longer a client can defer the payment of tax the better, because he or she can use and invest that money. Here are some of the opportunities the IRS gives us to defer the tax on income: Exchange of Insurance Policies (Code Section 1035) Allows the exchange of a current policy for one with better underwriting or a better product. Often the gain in the current policy is used to partially fund the new policy. Like-Kind Exchange of Tangible Property (Code Section 1031) Relinquished tangible property must be of a “like kind” to the replacement property (for example, a herd of cattle cannot be exchanged for a commercial building), and the exchange must occur within certain timing requirements (45 days for identifying and 180 days for acquiring the replacement property). No constructive receipt of cash is allowed in a non-simultaneous exchange, so a qualified intermediary is often used. To completely defer gain recognition, the value of the replacement property must be greater than or equal to the value of the relinquished property, and the taxpayer’s equity in the replacement property must be greater than or equal to the taxpayer’s equity in the relinquished property. If either is not true, there will be a taxable “boot” that is recognized in the year of the exchange. Tangible property not eligible for a 1031 exchange includes stock in trade or other property held primarily for sale. Intangible property, such as stocks, bonds, notes, other securities or evidences of indebtedness or interest, partnership interests, and certificates of trust or beneficial interests are not eligible for section 1031 exchange deferral. Certain Corporate Reorganizations (Code Section 368) Certain corporate reorganizations permit corporations to merge and acquire each other on a tax-free basis, which allows the client to rearrange corporate structure without an immediate income tax. Installment Sale (Code Section 453) Generally, if property is sold at a gain and at least one payment is received after the close of the tax year of sale, installment reporting is required unless the taxpayer elects out. There are many specific rules that apply to installment sales. Charitable Trusts In the right circumstances, charitable trusts can also provide tax deferral. Charitable Remainder Trust (CRT) The grantor retains an annual income stream and the remainder, if any, at the end goes to charity. The annual income stream can be an annuity or a “unitrust”: i.e., an amount that is a fixed percentage of the balance of the trust at the beginning of the year. The net present value of the remainder interest when the trust is created must be at least 10% of the value of the initial contribution. The annual distributions can be payable for a term of years, a single life, joint lives or multiple lives. Tax Deferral with a CRT A CRT is exempt from income tax because the ultimate beneficiary of the trust is a charity. There will be no capital gain tax when appreciated property is placed in the trust or when it is sold by the trust. Capital gain is eventually taxed as annual payments are made to the grantor, but only after ordinary income has been taxed. Distributions that exceed ordinary income and accumulated capital gains are tax-free. The client also gets a charitable deduction in year one for the present value of the remainder interest. Charitable Lead Trust (CLT) With a CLT, a charity is the beneficiary that gets a stream of annual payments and the remainder, if any, goes to the grantor or whoever the grantor chooses. A CLT is funded with income-producing assets that are ultimately earmarked for heirs. At termination of the CLT, the trust assets pass on to the heirs free of any transfer tax on appreciation realized after the date the trust was created, as long as the rate of return on the assets exceeds the AFR in effect when the CLT is established. The taxable gift to the heirs is calculated in the year the CLT is created if the stream of payments is an annuity, or at termination if the CLT is a unitrust. When the grantor gets a charitable deduction depends on whether the CLT is a grantor trust. Tax Deferral with a CLT A CLT is not exempt from income tax because the ultimate beneficiary of the trust is not a charity. If it is a non-grantor CLT, there is an income tax deduction for the amount paid to the charity each year. If it is a grantor CLT, the charitable income tax deduction can be accelerated and taken on the grantor’s income tax return in the year the trust is created. This can be very beneficial for a client who has a substantial amount of income in one year. All taxable income earned by the trust in future years will then be taxed to the grantor. Conclusion Income tax planning should be an integral part of the estate planning process. We hope that this review will be useful for issue spotting and serve as a reminder that we need to work together as a team in order to provide the best possible service for our mutual clients.