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Understanding the Fiscal Cliff Legislation

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.


Don’t Let the Tax Tail Wag the Dog: Client Concerns, Not the Estate Tax, Should Drive Estate Planning

Washington’s negotiations about 2013 tax laws are getting lots of press. As estate planning professionals, we are often asked our opinions about what the 2013 estate tax laws might be and the resulting implications for our clients. But for the vast majority of Americans, what the estate and gift tax laws will be in 2013 is really irrelevant. Those who could make large gifts have probably done so in 2012, and the 2013 estate tax exemption is only relevant to those who have a 2013 death.

Yes, it is important for us to be aware of the state of the tax law. We can keep our ear to the ground for warnings of change emanating from Washington, but nobody has any kind of a handle on what the law will be in 5, 10, 15 or 20 years! What we all need to do is redirect our clients’ inquiries to their real concerns: protecting their families and assets; preserving the family business; making sure their children are provided for, educated and motivated; seeing that their loved ones have enforceable rights where the law may not grant them; and making sure their plans do not self-destruct for lack of proper maintenance. These are the enduring issues that drive estate planning, regardless of what the estate tax law may be at any given time.

In this issue of The Wealth Counselor, we will take another look at one of those client concerns — asset protection. With our increasingly litigious society, asset protection planning has become more important and is often a key motivator for clients who need other estate planning, too.

What is Asset Protection Planning?
Asset protection planning is not hiding or concealing assets. Rather, it is helping clients use existing laws appropriately to obtain the best possible level of protection for their assets against possible attack by creditors. The goal is to make planning decisions that are effective if and when needed because they have legitimate non-asset protection purposes and thus are defensible.

The best and most effective time to implement asset protection planning is before a claim arises, when the client is merely worried that someday there may be claims founded on possible events that have not yet happened. But even after a claim has been made, some opportunities (such as making a contribution to an ERISA qualified plan or doing a Roth conversion) may still be available to shield some assets.

Types of Client and Asset Risks
Almost every client would benefit from some asset protection planning, but like most things in life there is a cost to achieve the benefit. Asset protection planning is advanced planning and requires collaboration from a team of advisors, so sometimes the cost outweighs the benefit. Therefore it is important that each member of the advisory team be able to recognize the types of clients whose profile indicates they might be good prospects for asset protection planning. Here are a few of the main ones:

The clients who are the best prospects for asset protection planning are those most likely to be sued. At the top of the list are physicians, surgeons, dentists and other health care professionals. Running a close second are lawyers, architects and accountants. A third category is clients involved with business enterprises that pertain to health care, such as skilled nursing facilities and assisted living facilities. Builders, developers and others in construction are also at risk. Those who have already gone through a lawsuit will be keen to avoid the fear of loss associated with another one.

Planning Tip: A professional is liable for the consequences of his or her own negligence and everyone makes mistakes. Therefore, a professional’s liability protection should begin with adequate malpractice or errors and omissions insurance coverage.

In a general partnership, each partner is liable for the negligent acts of every other partner and every employee. It is rare to encounter a general partnership of medical professionals, but much more common with lawyers and architects. Plus, partnerships can come into existence without any paperwork as a business is started and then the clean-up sometimes doesn’t get done as the business grows.

Entrepreneurs and Executives
Attacks on entrepreneurs could come from business deals that have gone bad or tort claims. Management level personnel are exposed to claims for alleged improper employment practices, employment discrimination, or sexual harassment.

Clients who own residential rental properties have often acquired them one-by-one over time. Frequently they are owned in the landlord’s name. Every residential property exposes its owner to premises liability claims, such as for injuries from fires and slip-and-fall accidents. Legal structures can be set up that isolate a property from these risks associated with another property and separate the landlord from all the risks.

The Wealthy 
The wealthy are exposed to more risk of lawsuits because they have the ability to pay and juries are often sympathetic to the plaintiff when the defendant is rich. Also, they often have staff, multiple properties and multiple vehicles and those impose claim risks, too.

Lifestyle-Based Candidates
Clients who have had more than one spouse are statistically at higher risk of divorce than those in first marriages. Many a business has collapsed as a result of an ex-spouse claiming an ownership interest in the business.

A client’s child who engages in risky or antisocial behavior creates a risk of future unnecessary dissipation of a family’s wealth; often leaving the child destitute with no one to turn to once the parents are gone.

Levels of Asset Protection
Every asset protection plan is a unique creation designed to meet the particular client’s needs, risks and concerns. Typically, an asset protection plan employs a combination of strategies. Because asset protection planning is a process that frequently takes months to fully implement (and because wisdom dictates building the foundation before starting on the roof) in general asset protection planning should be implemented by levels, starting at the lowest. The lower rungs on the ladder don’t get you very far off the ground, but they are dangerous to skip. Asset protection planning works the same way. A typical planning level strategy that would be presented to a highly compensated professional in a high risk profession would be:

Level 1:           Exemptions
Level 2:           Transmutation or Tenancy by the Entirety Agreements
Level 3:           Professional Entity Formation (PA/PC/PLLC)
Level 4:           FLP/FLLC to Own and Lease Practice Assets
Level 5:           FLP/FLLC to Own Non-Practice Assets
Level 6:           Domestic (U.S.-Based) Asset Protection Trusts
Level 7:           Offshore Asset Protection Trusts

Below we discuss each of these seven levels.

Planning Tip: The plan presented should include levels above those that the client will probably choose. This gives the client appropriate control and decision making responsibility and also avoids the risk of the client legitimately complaining that particular strategies were not offered.

Level 1: Exemptions
Some assets are automatically protected by state or federal exemptions. State exemptions can include personal property, life insurance, annuities, IRAs, homestead, and property held in tenancy by the entirety. Each state protects its citizens’ assets differently and the amounts of the exemptions will also vary greatly from state to state. For example, some states have an unlimited homestead exemption; many states protect all IRAs; and many non-community property states recognize tenancy by the entirety, which is sometimes a great way to shelter the interests of both the spouse who is at risk and the spouse who is not.

Federal exemptions include ERISA which covers 401(k) and 403(b) plan accounts, pensions, and profit-sharing plans. Creating and funding qualified retirement plans for clients can provide excellent shelters against creditors’ claims. Typically these plans must also include one or more non-owner employee participants in order to be covered by ERISA. Skillful pension actuaries can be very helpful with this.

While the federal Pension Protection Act protects up to $1 million in IRAs and Roth IRAs for bankruptcy purposes, the level of non-bankruptcy protection afforded by the states to their citizens’ IRAs varies widely.

For a client who lives in a state with weak IRA protection, it might be best to move unprotected IRA assets into an ERISA qualified retirement plan which is unreachable by third-party creditors during the pay-in period (some portion of required minimum distributions may be reachable by creditors). For the client who lives in a state with strong IRA protection or who has not used all of the IRA protection available in their state, converting a traditional or roll-over IRA into a Roth IRA and paying the taxes with non-IRA funds can be an excellent asset protection strategy that is easily and quickly implemented.

Planning Tip: With today’s low interest rates, defined benefit plans are becoming popular again. Instead of the required annual fixed contributions of the past, the IRS now allows almost as much flexibility with defined benefit plan contributions as it does with profit-sharing plans. Contributions can also be increased dramatically to allow for the use of life insurance within the plan. Life insurance can be an especially valuable asset because death benefits are not subject to income or capital gain tax, and if the policy ownership and control is done right, the death benefit is not part of the insured’s taxable estate.

Planning Tip: Sometimes it is possible to convert non-exempt assets into exempt assets. For example, cash (a non-exempt asset) can be used to pay down a homestead mortgage and increase exempt home equity. This is a strategy for clients who live in states with a large or unlimited homestead exemption.

Planning Tip: Because home mortgages and home equity lines of credit are currently hard to get, a qualified personal residence trust (QPRT), established as an ongoing trust to benefit younger family members, can also be used. However, because it is a self-settled irrevocable trust, some states have limitations that can reduce a QPRT’s effectiveness for asset protection. Also, putting an unprotected home asset into a QPRT when there is a known or anticipated claim could be held to be a fraudulent transfer.

Planning Tip: The exemption level asset protection strategies may even be available to the client who has already been sued.

Level 2: Transmutation or Tenancy by the Entirety Agreements 
There are asset protection strategies for married clients that depend on how title is held to an asset. In most of the states, the available technique is converting jointly held property to tenancy by the entirety property. In the nine community property states, the technique of choice is the agreement to transmute community property into separate property. Both techniques have legal consequences beyond asset protection that must be explained to, understood and accepted by the client.

Converting jointly held property into tenancy by the entirety can make it inaccessible to an at-risk spouse’s creditors while the other spouse is living. Transmutation agreements allow clients to convert community property assets into the separate property of the spouse not at risk. Make sure the client is aware that property once transmuted stays separate property unless and until another transmutation agreement converts it back to community property. Separate counsel for each spouse may be needed to make a transmutation agreement binding. Plus, there may be enhanced risk of loss of property in case of a divorce.

Level 3: Professional Entity Formation (PA/PC/PLLC)
General partnerships and sole proprietorships under which a professional is conducting business should be restructured as a professional association or corporation (which depends on state law) or a professional limited liability company. By so doing, each professional will become protected from personal liability for the errors of other professionals and employees. Putting that protection in place is a good second step beyond having adequate malpractice insurance.

State laws will vary on this. If available, a PLLC is usually more desirable because of the charging order limitations that prevent a professional’s creditor from seizing any assets from the entity, limiting the creditor to only receiving distributions that would have been made to the affected debtor-member. In addition, the creditor may have to pay tax on any income that is distributed under a charging order. This is often enough to discourage a creditor from pursuing a claim or to make settlement on a favorable basis possible. Establishing the entity under the laws of a state that has the charging order as the sole creditor remedy, when that is possible, should also be considered.

Level 4: LP/LLC to Own and Lease Practice Assets
An LP or LLC can be created to own the specialized or valuable equipment and/or real estate that is used in the professional practice. “Lease back” agreements can then be created between the professional practice and the property owning LLCs. This strategy allows the professional to isolate valuable real estate and equipment from malpractice exposure. In some cases, a factoring arrangement can put the value of the practice’s accounts receivable in the LP or LLC and thus beyond the reach of a malpractice creditor.

Planning Tip: Creating an LP or LLC to own practice assets also allows for good estate planning by providing the opportunity for gifting or sale of LLC/LP interests to irrevocable trusts established for the benefit of children or other family members.

Level 5: FLP/FLLC to Own Non-Practice Assets
Consider the formation of a family limited partnership or family LLC in a favorable jurisdiction that has the charging order as the sole remedy to own non-practice assets. This entity would hold personal use real estate, investment accounts, cash or bank accounts, and investment real estate. Having a multi-member LLC increases the charging order protection because a bankruptcy judge cannot collapse a multi-member LLC that was formed in a favorable jurisdiction.

Level 6: Domestic (U.S.-Based) Asset Protection Trusts
Historically, creditors were able to reach assets that their debtor had placed into an irrevocable trust for the debtor’s benefit. Such trusts are called “self-settled.” Starting with Alaska in 1987, several states have adopted laws that allow the assets of certain self-settled trusts to be protected from the grantor/beneficiary’s creditors. These trusts are called asset protection trusts. Because they are formed under a state’s jurisdiction as opposed to the jurisdiction of another country (see Level 7, below) this kind of trust is commonly referred to as a Domestic Asset Protection Trust (DAPT).

The time between creating the DAPT or placing an asset in the DAPT and the DAPT affording protection to that or all DAPT assets varies from state to state, with the shortest time being two years.  In like manner, the states have different lists of creditor or claim classes to which the DAPT’s asset protection does not apply. The most popular states for DAPT formation are, in alphabetical order, Alaska, Delaware, Nevada and Wyoming.

In Level 6 planning, the client establishes a DAPT in the selected jurisdiction and funds it with non-practice, non-leasing LLC assets.

Each DAPT state has its own rules that will need to be satisfied for a DAPT established under its laws to be effective. For example, the state’s DAPT law may require that a trustee have an office in that state or that some of the trust assets be held there. Associating local counsel in the chosen DAPT jurisdiction may be appropriate.

Planning Tip: Because clients today are often living into their 90s, it is wise to build flexibility into a DAPT or other irrevocable trust to accommodate changes in a client’s needs and family over several decades. To do this, the trust can be made changeable by an independent third party of the client’s choosing. This role is commonly referred to as the “Trust Protector.”

Planning Tip: A trust can be designed so that transfers to it are, for gift and estate tax purposes, completed or incomplete gifts. Incomplete gifts are included in the grantor’s estate for estate tax purposes and get a basis adjustment at death. The opposite is true for completed gifts that are not brought back into the grantor’s estate under what are called the “string” sections of the Internal Revenue Code (26 USC §§ 2035-38 and 2042). Be sure to determine what is best in each case.

Level 7: Offshore Asset Protection Trusts
The highest (and most expensive to establish and maintain) level of asset protection planning is founded on one or more asset protection trusts established under the laws of a foreign jurisdiction. (The Cook Islands, the Bahamas, Bermuda and the Channel Islands are all popular choices.) With an offshore trust, the assets are in the hands of a local trustee and are outside the reach of any U.S. court. However, there may be tax issues. Also, if the court orders the assets repatriated and they can’t be, the client could be cited for contempt and even jailed.

Planning Tip: An offshore asset protection trust should not hold assets in the United States over which a U.S. court could exert jurisdiction.

Implementing the Asset Protection Plan
The advisors independently and collectively will make a list of the client’s assets and determine what needs to be done with each one to implement the levels of planning selected by the client. It can easily take six months to a year to design, implement and fully fund a comprehensive asset protection plan, and it’s usually done in steps and pieces. During the process, it’s very important to keep the client informed and keep everyone on a timeline.

Protecting the Advisor Team
Asset protection planning can pose a risk to the advisor team members’ assets. Those risks need to be avoided. One risk is the client who, when his or her assets are under attack, will forget that no advisor guaranteed the plan’s success. The other risk is that the client’s creditors, who just want money and don’t care who pays, may try to bring the asset protection planning team members into the fray under “fraudulent transfer” allegations.

Tempering Expectations and Documenting the Agreement
To deal with the first risk, it is important to set some reasonable expectations for the client and for the client to be educated about what asset protection is, how the laws work, and what the client can reasonably expect to achieve. For example:
*    Most people would like to have a high degree of certainty of the outcome. The advisors have to temper that expectation by explaining how the law works and that there may be circumstances that nobody can effectively control. Asset protection is time consuming, but worthwhile. The end result should be considerably better than if the client had done no planning at all.
*    Many clients want to maintain control rather than shift assets to some unknown third party in a foreign land. The preferred approach is to maintain control or at least oversight over the assets.
*    An effective plan will discourage lawsuits from the outset. We cannot make our client’s assets appear not to exist, but we can create a structure that will make it less attractive for a potential plaintiff to go after our client than to go after someone who has done no planning. And we can enhance our client’s ability to negotiate a favorable settlement if liability is established.

We very highly recommend that a detailed written asset protection engagement agreement be signed in all cases. The agreement should spell out the plan goals, limitations and potential risks and negate the idea of there being any guarantee of success.

Avoiding Fraudulent Transfer Exposure
The natural tendency of the debtor is to hide assets to frustrate the creditor who would seize them. To deal with that problem, there are “fraudulent transfer” laws. Each state has one and there is one in the Bankryptcy Code. In general they allow a creditor to unwind certain transactions in which the debtor has transferred assets to another for anything short of full and fair consideration with the intent of hindering or defrauding creditors. These laws also impose personal liability on anyone who aids or abets the debtor in these activitites. Therefore, the advisor team members all want to make sure that they have a good defense to any frustrated creditor’s claim that they took any action that was reasonably calculated to aid their client in implementing a fraudulent transfer.

The key to the advisor team members avoiding exposure to a claim of abetting fraudulent transfer is to make sure to gather financial and objective information and to build a relationship with the client before designing or implementing the asset protection planning. Once the facts are known, no matter how bad they are, some level of asset protection planning can probably be done. Without knowledge of the facts, the asset protection plan designed by the advisors is likely to fail.

Planning Tip: Because the natural tendency of many is to procrastinate, often the client who seeks asset protection planning already has a claim pending or impending against them.

Planning Tip: Because asset protection planning is most attractive to those who have a higher than average risk of being sued, it is critically important to determine early in the planning process how much information the client is willing to share and should share with various members of the advisor team. For example, it may be vital to preserve attorney/client privilege about some things and therefore not share specific risk information with non-attorney advisors who could be subpoenaed. Short of being sued, there is not much worse for an advisor than to be called to testify against a client!

Planning Tip: Clients may misrepresent their legal difficulties, and none of us wants to subsidize a plaintiff’s claim through the use of our own malpractice insurance because of not asking the right questions or doing a thorough discovery. An excellent practice is to have in your file a solvency certificate from your client in which the client represents to you in writing that their net worth is a positive number and that the planning they are going to do will not render them insolvent. In some instances it is useful to obtain permission from the client in order to do due diligence and independently investigate to make sure you know the information provided is accurate.

Asset protection planning is just one client concern that can be the impetus that gets the client to do estate planning. While it is highly important that the advisor team members know and understand the current estate tax laws, nobody knows what those laws will be in the future when the client’s planning “matures.” Other than in very rare cases, the current tax laws themselves are irrelevant to, and are rarely the motivating factor for, our clients’ planning. What our clients want and need is predictability coupled with flexibility. Members of the advisory team who are aware of the enduring concerns clients have will find many opportunities to work together for the benefit of the team members and their clients.

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.

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.

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.

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.