Legislators were very busy New Year’s Eve and into the early morning hours of New Year’s Day to draft and ultimately pass legislation to avoid what was commonly referred to as “The Fiscal Cliff.” But what really happened? In summary, not much new was passed, but rather the legislation in large part made permanent the system of estate and income tax that has been in effect for the past two years. The new law did put off for two months some important spending cuts that must take place due to a process called “sequestration.” It is these additional cuts that could have a significant impact on our senior population and their loved ones.
This issue of the ElderCounselorTM will take a look at the new legislation and what is yet to come in the next several weeks in the way of spending cuts, including possible cuts to programs that serve the elderly.
The Bottom Line on What Was Passed
This newsletter provides a summary of the legislation that was passed and what remains to be decided. If you have questions or need additional information, please contact us directly.
Estate taxes. An estate tax is a federal tax (and in some states also includes a state tax) on the transfer of a deceased person’s assets to his heirs and beneficiaries, and can include prior transfers made to those heirs and beneficiaries. However, under federal law, there is a certain amount that can be transferred without incurring any tax liability. In 2010, every individual could transfer (gift) up to $5 million tax-free during life or at death to avoid paying estate taxes on that amount. This amount is called the “basic exclusion amount” and is adjusted for inflation (usually on an annual basis). In 2012 it was raised to $5.12 million per person.
This year’s new “fiscal cliff legislation” did not change how much an individual could transfer during life or at death to avoid paying federal estate taxes on that amount. And, on January 11, 2013, the IRS announced that the estate tax exclusion amount for individuals who die in 2013 is now $5.25 million, as the prior figure has now been adjusted for inflation.
What if no action had been taken with regard to estate taxes?
Without the new legislation, the $5.12 figure would have automatically reverted to $1 million per person, and the rate for most estates would have gone up to 55%. Instead, the only thing the new legislation changed was the gift and estate tax rate, which has gone up to a top rate of 40%, from a maximum of 35% in 2012.
Married couples. The new legislation did not change prior law that stated that spouses do not have to pay estate tax when they inherit from the other spouse. Rather, when the first spouse dies, the other spouse can inherit the entire estate and any estate tax due would be postponed until the second spouse dies. This is called the “marital deduction.” If the surviving spouse is not a U.S. citizen, then there are restrictions on how much can be passed to the surviving spouse tax-free. It is also important to remember that this type of tax benefit between spouses is not always automatic – any married couple who may be subject to estate tax should seek the advice of an attorney to make sure their estate plan is properly set up to take advantage of this particular tax incentive.
What about lifetime gifts? The current basic exclusion amount of $5.25 million per individual is an exclusion for both lifetime gifts and gifts at death. This is often referred to as the “unified credit” amount. For example, an individual could transfer assets of $2 million duringtheir lifetime and an additional $2.25 million at death, and the total, $5.25 million, would not be subject to either gift or estate tax. However, if an individual transferred more than the $5.25 limit, that individual (or the heirs) will owe a tax of up to 40%.
The donor should report any gifts made during their lifetime to the IRS so a proper calculation can be made at the donor’s death. Using the above example, the $2 million lifetime gift would have been reported to the IRS even though no gift tax would be due. And, the IRS would then know that individual had $2.25 remaining to pass at death free of estate taxes.
There are additional gifting advantages available to married couples during their lifetime, and advice should be sought from an attorney versed in this area to determine what, if any, gifting incentives may be available.
Lifetime gifts that do not count toward the $5.25 million exclusion amount. There is an amount each year that can be transferred without counting toward the $5.25 exclusion amount. In 2013, that amount is $14,000 per year, per person (called an “annual exclusion amount”). For example, an individual can give three different people $14,000 in 2013, and it will not count toward the $5.25 lifetime exemption amount. Couples can double this amount and give $28,000 per person per year.
Planning Note: It is important to remember that any gift (unless designated as an exempt transfer under the federal and state Medicaid rules) will cause a penalty for Medicaid purposes. Individuals often believe that because they can transfer $14,000 per year per person under the tax rules, the same applies to Medicaid. The rules are very different for Medicaid, and a penalty will apply if that type of gift is made.
Changes to the income tax rules. This newsletter highlights the main points of the income tax rules that could directly affect seniors and their loved ones. For additional information on the alternative minimum tax or charitable gifting, please contact us directly.
In prior years, everyone enjoyed a 2% Social Security tax reduction as a stimulus measure. Under the 2013 legislation, this “tax holiday” was not extended; therefore, everyone will see a decrease in their net pay.
Ordinary income tax rates increase from 35% to 39.6% for singles earning more than $400,000 a year ($450,000 a year for married couples). All other ordinary income tax rates effective in 2012 were made permanent.
For those individuals earning over $250,000, and for married couples who earn over $250,000, there is a new Medicare 0.9% surtax on ordinary income and a new 3.8% surtax on investment income. These additional taxes were part of the 2010 health care legislation, much of which begins implementation in 2013.
The top capital gains and dividend rate increased to 20% for those earning more than $400,000 a year ($450,000 for married couples).
Additional Cuts Are on the Way
The current fiscal cliff legislation did not address the automatic spending cuts that were to take place on January 1, 2013. Instead, the automatic cuts, known as sequestration, were pushed back two months to March 1, 2013. Sequestration was one portion of the spending cuts included in the Budget Control Act, passed and signed in August 2011.
The Budget Control Act of 2011 allowed the president to raise the debt ceiling by $2.1 trillion, and it instituted two rounds of significant spending cuts. One round of cuts involved government programs like defense spending, education funding, the FBI and other government agencies that would receive automatic budget cuts relative to their scheduled growth over the next 10 years.
The second half of the spending cuts was supposed to be decided on by Congress through a Joint Select Committee on Deficit Reduction. This Committee (referred to as the “supercommittee”) was to come up with a list of cuts that would then be put to Congress for a full vote. If the committee couldn’t agree on the cuts, $1.2 trillion in further spending reductions over 10 years would be implemented starting Jan. 1, called the “sequester.” No cuts have yet been agreed upon, and the automatic spending reductions have been moved back to March 1, 2013, to allow Congress time to come to an agreement.
Programs like Medicare, Medicaid and Social Security have been the topic of discussion for the second portion of the spending cuts. We will continue to monitor and report on the progress of Congress as it pertains to these spending cuts and how they will impact our senior population and their families.
The fiscal cliff legislation is in place; however, there is more legislation to occur that could have a significant impact on those affected by programs like Medicare, Medicaid and Social Security. While many families may not be affected by the current estate and income tax rules, there are many who could have their life savings consumed by long term care costs. We help seniors and their families plan ahead to avoid a financial crisis, even if a health care crisis occurs. If you would like to learn more or if we can help someone you know, please give us a call.
To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.
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.
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.
|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.
Deferred (“Planned Giving”) Gifts
What Charities Do with the Money They Raise
How Charities Organize Their Fundraising Efforts
How Development Officers Are Compensated
How You Can Work Together
What the Development Officer Can Bring to the Team
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
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
Cultivating Development Officers as Referral Sources
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.
|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
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
Advanced Estate Planning Can and Often Does Have Income Tax Implications
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:
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
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
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
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.
Getting Out of the C-Corporation Trap
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
Exchange of Insurance Policies (Code Section 1035)
Like-Kind Exchange of Tangible Property (Code Section 1031)
Certain Corporate Reorganizations (Code Section 368)
Installment Sale (Code Section 453)
Charitable Remainder Trust (CRT)
Tax Deferral with a CRT
Charitable Lead Trust (CLT)
Tax Deferral with a CLT
You want a satisfying, long-term relationship with clients, meaningful recurring revenue and referrals from existing clients. Your clients want a trusted advisor relationship with you and they want coordinated estate, financial and tax planning that protects them, their family, and their business interests.A client update process or financial control system is an essential strategy that will assure these outcomes over time. It also creates the opportunity for recurring, positive contact between the various members of the client’s estate, financial and tax planning team.In this edition of The Wealth Counselor, you will learn some strategies for how to implement and/or improve a client update process/financial control system in your practice. You will also learn how to manage it so that it will produce a winning situation for the client and the various members of the advisory team.
Coming Together as a Financial Lifeguard for the Client
The team approach brings together the attorney, investment advisor, CPA, and insurance professional, among others. Sometimes it is the attorney who holds the team together; other times it is the CPA or financial advisor. Whoever it is, the key thing to remember is that no one advisor is as smart as all of them are together. All are needed to meet the client’s needs, and often the help of one or more team member is required to move the client forward in the planning process.These three questions will guide the team through the process of arriving at a joint planning recommendation:
* For what purpose? This sets up the situation and the next steps.
* By what means? This creates a pattern of expectations. While there may be many options to explore, this helps to structure an agreement as to how the team members will be paid (full disclosure is required).
* What are the consequences? This helps to complete the action and may veer to an unexpected direction requiring innovation when an adverse consequence is identified. The team solves the problems and meets the client’s needs.
The Registered Investment Advisor’s Role
Because registered investment advisors may be audited at any time by the SEC or by the State, they must monitor their compliance with the applicable regulations. They must keep careful records, and information must be presented and recorded accurately. Disclosure brochures must also be used.
Planning Tip: Before the client meeting, the advisors can discuss whether sensitive information that might need to be protected by the attorney-client privilege is likely to come up and if team members will, therefore, need to exit the meeting while these private matters are discussed. Letters, memos and other documents passing between the attorney and the client also may need to be kept within the protected environment of the attorney-client privilege
Investment advisors develop Investment Policy Statements; provide cash management and long-term investments; establish appropriate performance benchmarks; adapt to changing conditions and family objectives; and monitor and provide performance reporting.
Investment advisors maintain account documents and records. An internet service may be used to provide easy, 24/7 accessible storage of these records and the investment advisor shares this information appropriately, as determined by the client.
Planning Tip: It is best to allow the client to determine which advisors and family members will have access to which information. Secure internet-based document vault services (e.g., The Advisors Forum’s ClientDocx) can provide record storage with varying access authorizations depending upon the particular person’s need to access specific information.
Investment advisors keep up to date on investment strategies, tax codes, philanthropic concepts, etc., and can provide ways to teach younger generations about money and financial concepts.
Planning Tip: It can be a good idea to bring in the younger generation to review meetings in order to introduce them to the planning concepts and the team of advisors. With the client’s consent, this can introduce them to the concept of wealth and wealth management over a period of some time, as opposed to their suddenly inheriting wealth with little or no preparation to manage it.
Client Update Meetings/Financial Control System
Using a financial control system for the client meetings lets the team identify tasks (pre-implementation, implementation and ongoing maintenance) and assign responsibilities.
Pre-Implementation Tasks (Planning or Discovery Phase)
* Client meetings will likely occur in person or, in some cases, via teleconference (like “GoToMeeting”). Meetings should have a written agenda, an assigned record-keeper for minutes, information sharing (“DropBox” can be useful) and secured document storage. Keeping notes about follow-up actions to take shows the advisor is organized and provides protection in case of an audit.* Investment evaluation includes making financial projections, determining a risk profile, and developing an investment policy statement with asset allocation and sensitivity analysis.* Insurance evaluation includes determining a need, structuring ownership and beneficiaries, designing policy features, and establishing funding levels and sources. Existing policies can often be replaced with a better product at no extra cost to the client.
Before implementing the plan, the team will need to review legal documents, verify ownership and titling, have signed advisory agreements, fully disclose any fee sharing and continue to update the client checklist.* Investment tasks in this phase include a recommended investment policy, the investment advisory agreement and a letter of intent for funding the investment accounts with different levels of risk. Accounts will then be established and funded.* Insurance tasks in this phase include the application and underwriting process for any new policies and a review of existing policies.
Planning Tip: The attorney and investment or insurance advisor will need to work together, especially if there are multiple beneficiaries in the plan.
* Investment tasks include monitoring investment results, rebalancing investments and preparing reports, with copies typically going to the attorney and CPA.* Insurance tasks include obtaining in-force illustrations, analyzing results, determining funding levels and allocating cash or variable values.* Legal and Accounting tasks are mostly concerned with compliance and include tax and accounting, funding, payments to beneficiaries, sending Crummey notices, and creative task sharing.
Planning Tip: The attorney, investment advisor and CPA should discuss details in person or by telephone to make sure everything is implemented and reported correctly in order to avoid costly mistakes. For example, Crummey notices should be issued to make sure the annual gifts qualify for the gift tax annual exclusion; QTIP elections must be made (there is no forgiveness if the box is not checked); transfer of trust property after the grantor dies must be implemented properly, etc.* Administrative tasks are also ongoing. Documents and records must be maintained (on paper or electronically). Comprehensive financial information must be provided in custodial, performance and tax reports. Completed planning must be monitored and adapted to changes in the tax laws and regulations; family needs and goals (i.e., there is often concern over how to pay for long term care); financial and investment environment (i.e., there is more risk aversion today after the market meltdown in 2008); and philanthropic strategies (lifetime and/or after-death giving to church, charities).* Client Education: It’s important to connect with clients on an ongoing basis to let them know about new investment and planning strategies through newsletters, bulletins, quarterly education programs and seminars. Annual meetings and family retreats also provide an opportunity and environment to teach younger generations about money.
Everyone benefits when advisors come together to work for a client. The client benefits from the comprehensive estate, tax and investment planning; the younger generation benefits from the protection of these assets; and the advisors benefit again when, after building relationships with the younger generation, assets are kept under management at the incapacity or death of the first-generation client.Using a client update process or financial control system will provide the necessary framework for the advisory team to work from, so that everyone stays informed, on track and accountable to meeting the client’s changing goals and objectives.To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax adviser based on the taxpayer’s particular circumstances.
With the recent discussions about closing tax loopholes and increasing taxes for the “wealthy” incident to increasing the national debt limit, clients are beginning to fear that the taxes on their wealth will increase. Even without higher tax rates, wealthier Americans will pay more in taxes if allowable deductions (possibly charitable) and exemptions (probably estate tax) are lowered.
We need to be prepared to help our clients as they begin to draw down retirement savings and look for more tax-efficient investments for their stocks, bonds, real estate and savings.
In this issue of The Wealth Counselor, we will examine some of the top income tax planning ideas to implement in 2011 and 2012.
Income Tax Overview
Anything can happen between now and January 1, 2013, but, based on current law, that will be the date the top income tax rate increases from 36% to 39.6%, qualified dividends become subject to ordinary income tax rates, the tax on long-term capital gains jumps from 15% to 20%, and the 3.8% Medicare surtax kicks in (unless the Florida Federal District Court decision striking down the health care reform act is upheld). Let’s look more closely at how these taxes can impact your clients, and what you can do to help them.
Under current law, in tax years beginning on or after January 1, 2013, qualified dividends will be subject to ordinary income tax rates. Therefore, C Corporations with accumulated earnings and profits and the cash to do so should consider making larger dividends in 2011 and 2012.
Example, Distribution of C Corp Dividends: Should the sole shareholder of a C Corp make a $1 million dividend to himself in one lump payment in 2012 or in $200,000 increments over five years (2012-2016)? Assuming he is in the highest marginal income tax bracket, 15% capital gains tax rate on dividends in 2012, and 39.6% + 3.8% = 43.4% ordinary income tax rate on dividends for 2013 and beyond, he would pay $150,000 in taxes on the lump sum distribution in 2012 and $377,200 on the incremental distributions paid over five years. He would save $ 227,200 by taking the lump sum in 2012.
Long-Term Capital Gains
Under current law, in tax years beginning on or after January 1, 2013, long-term capital gains will be taxed at a top rate of 20%. Taxpayers should consider selling (or otherwise disposing of) appreciated property and recognizing the taxable gain in 2011 and/or 2012. Taxpayers who have realized capital gains deferred on an installment note may want to consider accelerating the unrecognized gain in 2011 and/or 2012.
Example, Acceleration of Gains: In 2012, Judy sold her business for $1 million in exchange for a nine-year installment note. At the time of the sale, she realized a $900,000 gain. By electing out of the installment treatment, she would pay $135,000 in capital gains tax on the lump sum in 2012 vs. $175,500 on the installments in 2012-2021, and would save $40,500 in taxes (900,000 x .15 = 135,000 versus 900,000 x .1 x .15 = 13,500 plus 900,000 x .9 x .2 = 162,000).
Under current law, in tax years beginning on or after January 1, 2013, ordinary income tax rates will increase to their pre-2001 levels. Taxpayers should consider accelerating certain types of ordinary income (bond interest, annuity income, traditional IRA income, compensation income) into 2011 and 2012 if they expect to be in the same tax bracket or higher in future tax years. This is especially true for top bracket taxpayers who may pay the 3.8% Medicare surtax on their “net investment income.”
Example, Accelerating Bond Interest: Mike has $100,000 of accrued bond interest that will be paid on January 3, 2013. Mike is in the 35% tax bracket for 2012 and 39.6% + 3.8% for 2013. If he sells his bonds (at par) before the end of 2012 and recognizes the accrued interest income, he will pay $35,000 in taxes vs. $43,400 if he waits and collects the interest in 2013, and will save $8,400 in taxes.
Example, Sale/Repurchase of Bond: James purchased $1 million of corporate bonds in 1993 at par value; they mature December 31, 2011. On December 31, 2012, he sold them for $1,050,000. On January 3, 2013, he repurchased the same bonds for $1,050,000. Under tax law, this $50,000 premium can be used to offset his interest income over the remaining life of the bond (one year). By selling the bonds in 2012 and repurchasing them in 2013, he realizes a net income tax savings of $14,200 ($21,700 in income tax savings on the bond premium, less $7,500 in capital gains tax on the sale of the bonds = $14,200).
Additional Income Tax Planning Ideas
Oil and Gas Investments
Intangible drilling costs (IDCs) provide a large immediate income tax deduction (up to 85% of the initial investment). Losses, if any, created as a result of IDCs will be ordinary and will lower the taxpayer’s Adjusted Gross Income. Depletion and other depreciation provide for additional deductions during the term of the investment. Additional tax credits may be available for certain oil and gas ventures.
Planning Tip: Be careful with oil and gas investment where the client may be subject to the alternative minimum tax (AMT). The AMT may limit the amount of deductions allowed.
Generally, gold held as coins or bullion is treated as “collectibles,” for which the long-term capital gain rate is 28%. All short-term capital gains are treated as ordinary income. Therefore, a taxpayer in a lower tax bracket would be better off triggering short-term rather than long-term capital gain on gold coins or bullion. On the plus side, the “wash sale rule” (explained below) does not apply to “collectible” losses.
Planning Tip: The “collectibles” tax rate does not generally apply to gold held in mutual funds or to non-exchange-traded options on gold. Gold futures must be “marked to market” and the unrealized gain/loss must be recognized each tax year. Moreover, gold futures gains are subject to special tax treatment (60% long-term capital gain or 40% short-term capital gain).
Foreign Currency Transactions
Gains and losses in foreign exchange transactions are ordinary income/loss rather than capital gain/loss. Generally, taxpayers will want to recognize ordinary income in 2011 and 2012 and push ordinary losses to 2013 and later years.
These have special gains treatment on certain broad-based listed options (60% long-term and 40% short-term). For taxpayers in the highest marginal income tax bracket in 2013, this would result in a blended capital gains tax rate of 29.36% ((.6 x .2) + (.4 x .434)).
Loss harvesting can apply to individuals, trusts/estates, and charitable lead and remainder trusts. Considerations include:
Wash Sale Rule: Capital losses are denied to the extent that a taxpayer has acquired (or has entered into a contract or option to acquire) a “substantially identical” stock or security within a period beginning 30 days before the sale and ending 30 days after the sale of a stock that was sold at a loss (“loss stock”). The disallowed loss on the loss stock is added to the cost basis of the new stock, and the holding period of the loss stock is carried over to the new stock. This rule also applies to ETFs, index funds, IRAs and taxable investment accounts. It does not apply to “collectibles.”
Diminishing Real Value of Capital Losses: Because of the cost of capital, the sooner a capital loss is used the better.
Efficiency of Capital Loss Offsetting: In general, capital losses are more tax effective if they can be used to offset income taxed at higher tax rates (short-term capital gains and ordinary income). Long-term losses used against short-term gains are tax-efficient. Short-term losses used against long-term capital gains are tax inefficient.
Income Shifting to Junior Generations
Income taxes can be saved by shifting income-producing assets from parents or grandparents who are in a high income tax bracket to their children and grandchildren who are in lower tax brackets. Planning considerations include asset protection (accomplished through the use of trusts) and the “kiddie tax” for beneficiaries under age 24.
What makes this most attractive in 2011 and 2012 is the $5 million per person gift tax exemption: a married couple can gift up to $10 million and no gift tax will be incurred on the gift. The gift can be made in trust and then used to invest and/or purchase life insurance on the donors.
Example: Husband and wife, who are taxed at the current top (35%) rate, own $16,000,000 in S Corporation stock. They gift $10 million of it to their four adult children (15 5/8% of the S Corporation stock to each child). The S Corporation income is $2 million per year. After the gift, 37.5% is attributed to the parents and taxed at their rate and 62.5% is attributed to the children and taxed at their lower rates (assume 25%). Annual income tax savings: $10,000,000 x 10% = $100,000.
Planning Tip: Income can also be shifted upwards. For example, a high-earning professional can make the gift to his/her elderly parents who are in a lower tax bracket. The additional income can be used to help pay for medical and/or assisted living expenses. After the parents die, the assets can go to the original donor’s children (if the “kiddie tax” does not apply) for additional income shifting.
Roth IRA Conversions
Benefits of converting include a lowering overall of taxable income long-term; tax-free compounding; no required minimum distributions (RMDs) during the owner’s life; tax-free withdrawals for beneficiaries; and more effective funding of the bypass trust. For most people, converting to a Roth IRA is highly beneficial over the long term.
Planning Tip: When exploring a Roth IRA conversion, consider the tax rate in the year of conversion vs. the tax rate in years of withdrawals; the owner’s ability to use outside assets to pay the income tax on the conversion; and the need for the IRA to meet annual living expenses.
Net Unrealized Appreciation (NUA) Planning
If an employee has employer securities in his/her qualified retirement plan, he/she may be able to convert a portion of the total distribution from the plan from ordinary income into capital gain income. The distribution must be made as a lump-sum distribution due to the employee’s death, attaining age 59 1/2, separation from service, or becoming disabled within the meaning of Code section 72(m)(7).
Taxation of Lump-Sum Distribution
Ordinary income is recognized on the cost basis of the employer securities distributed (a 10% early withdrawal penalty is due if the employee is under age 55 at the time of distribution). The difference between the fair market value at distribution and the cost basis is Net Unrealized Appreciation (NUA). NUA is not taxed at the time of distribution, but at a later time when the stock is sold, and is taxed then at long-term capital gain tax rates. (Ten-year averaging is available to those born before 1/2/1936; 20% capital gain applies to pre-1974 contributions only.)
Planning Tip: NUA does not receive a step-up in basis at death, although subsequent gain above the value at distribution should. Also, if an estate or trust contains NUA stock, a fractional funding clause must be used; otherwise, the NUA will be subject to immediate taxation.
If the capital gains tax rate increases to 20% and the 3.8% Medicare surtax applies, charitable remainder trusts (CRTs) could become very attractive again. That’s because appreciated assets that are transferred to a CRT are not taxed, so the full value of these assets is available to provide income to the donor, generating much more income than if the donor had sold the asset, paid the capital gains tax, and re-invested the proceeds.
Planning Tip: With the current historically low 7520 rates, charitable lead trusts can be used now by charitably inclined clients to shift significant wealth while using only an insignificant amount of their estate/gift tax exemption.
An IRA is treated as inherited if the individual for whose benefit the IRA is maintained acquired the IRA upon the death of the original owner. Under the tax law, the IRA assets can be distributed based upon the life expectancy of the beneficiary if the beneficiary is a living person or a trust that meets certain requirements, such as that it is irrevocable, all beneficiaries are natural persons, and the oldest possible beneficiary can be determined.
Spouse as Beneficiary
A surviving spouse named as beneficiary of the deceased spouse’s IRA may roll it over into a new or existing IRA in the spouse’s own name. The spouse is then treated as the owner and may delay taking required minimum distributions (RMDs) until he/she turns age 70 1/2 and then take distributions based on his/her life, often allowing for a greater stretch-out period.
Planning Tip: If the surviving spouse is under 59 1/2, rolling over can expose him/her to the early withdrawal penalty if the IRA funds are needed before the surviving spouse reaches 59 1/2. Safer strategy is to wait until then to roll over and use the inherited IRA withdrawal rules before then.
Non-Spouse as Beneficiary
Naming a non-spouse beneficiary avoids having the IRA assets being subject to estate tax in the surviving spouse’s estate. Required minimum distributions (RMDs) occur over the life expectancy of the designated beneficiary.
Common Inherited IRA Mistakes to Avoid
For non-spouse beneficiaries, it is critical to keep the inherited IRA in the name of the deceased IRA owner. Correct wording for an individual: “John Smith, deceased, IRA for the benefit of James Smith.” Correct wording for a trust: “John Smith, deceased, IRA for the benefit of James Smith as Trustee of the Smith Family Trust dated 1/1/2010.”
Other mistakes include not taking required minimum distributions, not using disclaimers when appropriate, not analyzing contingent beneficiaries, and taking a lump-sum distribution at the death of the IRA owner.
Life Insurance Planning for Inherited IRA
If the IRA owner’s taxable estate does not have sufficient other assets, it could be necessary to use a portion of the IRA to pay estate taxes. Because this use triggers additional income taxes, between 60-80% of the IRA could be lost to taxes.
A solution is to establish an Irrevocable Trust that holds a life insurance policy on the IRA owner’s life. Upon his/her death, the death benefit proceeds can be used to provide liquidity to the IRA owner’s estate and preserve the inherited IRA. To the extent that the grantor does not hold any “incidents of ownership,” none of the trust assets will be included in his/her taxable estate. Another alternative is to annuitize the IRA and contribute the annuity payments to the Irrevocable Trust where they are used to pay premiums for life insurance on the IRA owner.
The current income tax laws and the tax increases that will happen in just 16 months (unless the Congress and President agree otherwise) provide some unique opportunities for estate planning professionals to work together as a team to help our mutual clients. Take advantage of this limited time to meet with your clients, ask the right questions, and make a positive difference for them and their families.