Estate Planning 2013: Now What? A Must Read For Everyone

We now know what the federal estate tax laws will be this year and in the future.  Our federal government has stated that these estate tax rules are now permanent after a decade of uncertainty.  (A cynic may say that these federal tax laws are permanent until our federal government says they are not!). Anyway, here are some of the more important federal estate tax law changes made on December 31, 2012 along with some related estate planning strategies:

• The federal estate and gift tax exemption is now permanently (there is that word again) $5,000,000, with annual inflation adjustments.  These inflation adjustments generate exemptions of $5,120,000 in 2012 and $5,250,000 in 2013.
  • A husband and a wife each have this exemption, so a family can transfer $10,500,000 free of federal estate taxes in 2013. These very generous tax exemptions will allow the opportunity to transfer large amounts of wealth during lifetime or at death free of federal taxes.
  • Planning Point:  Taxpayers who used their full $5,120,000 exemption in 2012 can now make more gifts of $130,000 in 2013.
  • Planning Point:  With inflation adjustments each year, taxpayers can continue to transfer more each year.
  • Important Shift in Focus To State Inheritance Taxes:  Understand that we are only talking about federal estate and gift taxes and that these large exemptions are only applicable at the federal level. With these large federal exemptions, for most people, estate tax planning now will focus more on minimizing state inheritance taxes. For example, Pennsylvania does not follow the federal exemption rules and taxes almost all assets owned by a decedent.  To learn more about Pennsylvania inheritance tax rules see Pennsylvania Inheritance Tax: The Basics.
• Once assets are above the exemption threshold the estate tax rate is 40%.  This results in a very heavy tax bite and is a real concern for anyone above the threshold.  The following taxpayers may end up above the threshold:
  • A taxpayer or a surviving spouse with assets above the exemption threshold or
  • A family (husband and wife) that has accumulated wealth above the $10,500,000 threshold, or
  • A taxpayer that has made lifetime gifts that have exhausted or substantially depleted their exemption.  See the following Example 1.
• The tax law changes have once again unified the exemption for lifetime gifts and transfers at death.  So, if you use your exemption during your lifetime it is not available when you die.
  • Example 1:  Generous John, gave away his shares of stock of his business corporation valued at $5,000,000 to his son in 2012.  He uses his $5,000,000 exemption to transfer such shares free of gift tax.
  • Example 1A: Generous John dies in 2013 with other assets of $1,250,000 that make up his taxable estate. In 2013, he has a remaining exemption of $250,000 (2013 exemption of $5,250,000 less the $5,000.000 of his exemption used in 2012). Generous John has a taxable estate of $1,000,000 which results in a $400,000 in federal estate tax liability.
• Portability is now permanent.  Portability allows for the exemption that was not used by the first spouse to die to be used by the surviving spouse.  In theory, this provision protects those who have failed to plan or for those who have made errors in estate planning.
  • Important Planning Point:  Portability should be looked at as a fallback position where there was no estate planning done.
    • Employing traditional estate planning techniques may prove more advantageous and in some cases is essential in crafting a well conceived estate plan. For example, in most situations the combined use of a unified credit and a marital deduction trust (or the use of a disclaimer trust mechanism) would result in better tax outcome than relying on portability.
    • In second marriages, it is often imperative to use  a certain form of marital deduction called a Qualified Terminable Interest Property (QTIP) trust, to provide for both the surviving spouse and children of a first marriage.
    • Where assets are expected to appreciate in value over time, use of a by-pass or unified credit trust would offer a better result than relying on portability.
  • There are some very important limitations and concerns with using portability, especially in second marriages or where the surviving spouse remarried.  These issues are more fully explored in my article entitled Estate Planning Mistakes: 5 Not So Easy Pieces.
  • Portability Does Not Save the GST Exemption:   The new tax act provides that the Generation-Skipping Transfer (GST) tax exemption also remains at the same level as the gift and estate tax exemption ($5,000,000, adjusted for inflation). The GST tax, which is in addition to the federal estate tax, is imposed on amounts transferred (by gift or at death) to grandchildren or others more than one generation below the decedent.  The important point here is that “portability” does not apply to the generation skipping transfer (GST) tax rules. Where grandchildren and future generations are part of an estate plan, portability will not save the unused GST tax exemption of the first spouse to die.  In such cases, using something called a “dynasty” or GST exempt trust is the better course of action.
    • Caveat:   In situations where there the estate size is large and there are many generations who are going to share the estate, failure to understand and use the more traditional dynasty trust could result in a very expensive and disastrous mistake.
• Annual Donee Exclusion:  Although not part of the tax law changes, this traditional estate and gift tax planning tool allows for annual tax-free gifts of $14,000 in 2013 (up from $13,000 in 2012 as a result of the annual inflation adjustment).  As a result, taxpayers can now give up to $14,000 to as many people as they wish each year and not use up their unified credit or pay a gift tax.
  • Important Note:  Only gifts that qualify as “present interest” gifts are eligible for the annual donee exclusion.
  • Planning Point:  If you are married, your spouse can join you and, together, you can give up to $28,000 per person per year.
  • Planning Point:  This exclusion is in addition to the $5,250,000 estate tax exclusion and can be combined with such exclusion.  For more insight into how to combine these exclusions as well as the lack of marketability and minority interest discounts please read Gifting Shares of Stock In A Bad Economy.
• Capital Gains and Basis Implications:  Lifetime Gifts versus Transfers At Death:  Although not an estate tax rule, under the new federal tax rules, capital gains on appreciated assets will now be taxed at a 20% rate for taxpayers with income above certain thresholds.  Capital gains below these thresholds will be taxed at the previous 15% rate.  These rules bear heavily in the estate tax planning context especially where recipients receive lifetime gifts versus gifts received at death.
  • Important Tax Basis Rule:  Taxpayers who receive appreciated property by a lifetime gift take a carryover basis, while beneficiaries who receive assets at the decedent’s death get a step up in basis to the date of death value of such assets received.
  • Tax Disaster for the Uninformed, Do It Yourself Estate Planners:  Many times elderly people transfer real estate to children during their lifetime in trying to avoid probate.  For a recipient of such lifetime gift, a disastrous income tax result awaits the uninformed taxpayer as illustrated by the following Example 2.
  • Example 2:  Sam Senior is very sick and wants to avoid probate.  He transfers by quit-claim deed his real estate to his son, Sad Son.  Sam Senior bought his house in the 1970s for $17,000 and made improvements over time of $23,000.  As a result his adjusted basis is $40,000.  The house is now worth $540,000.
    • Sam Senior transfers the house to Sad Son in 2012.  Sad Son takes a carryover basis for the house of $40,000. Sad Son sells the house for $540,000 shortly afterwards and has a capital gain of $500,000 which he surprisingly and sadly finds out will cost him $100,000 (20% x $500,000) in federal taxes alone.  His accountant tells him there will also be state income taxes on this gain. Since he is a Pennsylvania resident, he will pay an extra $15,350 in Pennsylvania income taxes.
    • Alternate Universe:  Sam Senior consults with his tax/estate attorney who drafts a will that transfers the house to son at death. Sad (who now legally changes his name to Happy), has a basis of $540,000 upon his receipt of the house from the estate.  Happy, now sells the house and has zero, yes, zero capital gain (Sale Price, $540,000 less basis of $540,000 = 0)!
      • Note, state inheritance taxes may be applicable in certain states.  For example, in Pennsylvania there would be a 4.5% inheritance tax on the real estate, but this is a lot smaller cost than the capital gains that results from taking a carryover in basis via a lifetime gift.

Final Thoughts and Recommendations:

Federal Estate Tax Implications: The federal estate tax law changes provide for some very generous federal estate tax breaks.  For those close to or above the federal estate tax threshold, the discussion above has explored some of the many planning opportunities to save federal estate taxes.  Such taxpayers should not rely on portability and should meet with an estates attorney to plan the proper course of action based on their particular family situation, needs and goals.

Shift In Focus To State Inheritance Tax Matters: Taxpayers below the federal estate tax thresholds also must continue to plan but the tax focus needs to shift to minimizing state inheritance taxes.

Create An Estate Plan That Fits Your Particular Family and Financial Situation:  It is most important to recognize that everyone has a unique situation with various assets, family members and ideas on how their family members are to be provided for and who should be in charge once they are gone.  As a result, all taxpayers still need to set up an estate plan for non-tax issues such as making sure their assets go to their loved ones in the way they wish.  They need to choose the proper people to administer their estates and any trusts they create.

Young Families:  In younger families, determining a proper guardian for their children and setting up trusts for the protection of their assets and a distribution scheme for such children is of paramount importance and has little to do with taxes.  An objective and unbiased assessment of how much life insurance is required is often needed.

Second Marriages:  Many with second marriages face unique challenges.  An estate plan needs to be developed and implemented to meet the diverse needs and goals of such blended families.

Special Needs Trust:  Those with disabled children or those receiving government benefits may need special needs trusts.

Do Not Try This On Your Own:  Get an Experienced Estate Attorney:  Having experienced estate counsel explore these issues and offer various strategies is at the heart of estate planning.  Coordinating probate and non-probate assets into an integrated estate plan is often overlooked and little understood.

Attention To Details and Documentation: Finally, make sure that you have an experienced estate attorney that can create an integrated estate plan.  Such attorney should have the skills to draft appropriate wills, trusts, durable powers of attorney, living wills and other related documents tailored to your specific family and financial needs.

Please feel free to post comments or ask questions.  Liking and sharing this blog anywhere in cyberspace and recommending the site via the blue Alexa box on the right is always welcomed and appreciated.

As always, do not hesitate to contact me if they want further insight or need my advice or legal assistance.

Copyright © 2013 – Steven J. Fromm & Associates, P.C., 1420 Walnut Street, Suite 300, Philadelphia, PA 19102. All rights reserved. 

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2012 Year End Tax Planning Strategies

With less than 30 days left in 2012, there is still time to do some year-end tax planning.  This 2012 tax year is more difficult in that no one knows how the tax laws may change before the end of the year.  With certain tax deductions and credits due to expire at the end of 2012 (sunset provisions) and new higher tax brackets kicking in next year (end of the Bush-era tax cuts), year-end tax planning is harder than ever.

However, income tax planning must go on even in this uncertain tax environment.  As a result, it is essential to know the customary year-end planning techniques that cut income taxes.

It all starts with a tax projection of whether you will be in a higher or lower tax bracket next year. Once your tax brackets for 2012 and 2013 are known, there are two basic income tax considerations.

• Should income be accelerated or deferred?
• Should deductions and credits be accelerated or deferred?

Example: For income taxed at a higher tax bracket next year, accelerating such income to 2012 results in less taxes being paid.  At the same time deductions and tax credits deferred into next year will become more valuable as they offset income taxed at a higher bracket.

However, life is never that simple.  Tax law uncertainty, especially this year, makes for some real guesswork.  As discussed below, when it comes to certain deductions that have tax threshold limitations, bunching of deductions to one year may force the timing into a tax year where the tax bracket is lower than the other tax year in question. Year end tax projections must take into account the maddening alternative minimum tax.

In any event, the following lays out the basic ideas for income acceleration and deduction/credit deferral in a rising income tax bracket environment.

Income Acceleration: 

For taxpayers who think that they will be in a higher tax bracket, here are some targeted forms of income to consider accelerating into 2012.

• Receive bonuses before January 1, 2013.  If your employer allows you the choice, this may create some significant income tax savings.  Also, be aware that certain high income earners will pay an extra 0.9% in social security taxes on earned income above certain thresholds starting in 2013.
• Sell appreciated assets.  With capital gains being taxed at a higher rate in 2013, it may make sense to sell such assets before the end of the year.  For a complete discussion of this issue please see 2012 Year End Tax Planning: Should Taxpayers Sell in 2012 Before Rates Rise?  Important 

Example:  Mr. Appreciation has low basis stock that has appreciated by $200,000 as of December, 2012.  He thinks he will need to liquidate his positions either this year or next. His $200,000 gain will generate $30,000 in federal taxes in 2012 (15% tax).  If Mr. Appreciation waits until 2013, the tax rate may be 25% (or more due to the 2013 higher capital gain rate and 3.8 percent surcharge and itemized deduction limitations) with a tax of $50,000 in 2013.  As a result,  a sale in 2012 may save $20,000.

Note, however, that for an older taxpayer or one in ill-health, this strategy may not make sense since there would be no capital gains (because of the step up in basis rules) if the assets passed through his or her estate.

Planning Note:  The wash sale rules do not apply when selling at a gain, so taxpayers can cash out their gains and then repurchase the securities immediately afterwards.

• Redeem U.S. Savings Bonds.  Be aware that starting in 2013, a new 3.8 percent Medicare tax on unearned income, including interest, dividends and capital gains, will take effect.  So cashing in these bonds may make sense in the proper situation. For more on this read 2013 Sneaky New Tax – Not Too Early to Plan for 3.8 % Medicare Tax on Investment Income.
• Complete Roth conversions.  Taking into income the monies in IRA accounts in a year before your tax bracket is due to rise may make for some significant tax savings.
• Accelerate debt forgiveness income with your lender.
• Maximize retirement distributions.  Remember the minimum required distributions (MRDs) are the amounts distributed each year to avoid the draconian 50% MRD penalty.  However, taxpayers with IRAs can choose to take larger distributions this year to have such income taxed at a lower income tax rate than in 2013.
• Electing out or selling outstanding installment contracts.  Disposing of your installment agreement may bring the deferred income into 2012 at a lower tax rate than anticipated in future years.  It may be helpful to pay tax on the entire gain from an installment sale in 2012 by electing out of installment sale treatment under Section 453(d) of the Internal Revenue Code, rather than deferring tax on the gain to later years.  Conversely, in certain situations installment sale treatment may be a better option since it allows for spreading of income over multiple years which may keep taxpayers below the modified adjusted gross income threshold.
• Accelerate billing and collections.  If you report income on a cash basis method of accounting, immediately sending out bills to increase collections before the end of the year may result in significant tax savings.
• Take corporate liquidation distributions in 2012.  Senior or retiring stockholders contemplating the redemption or sale of their shares of stock in their corporation can save considerable taxes by selling their shares in 2012.

Deductions and Tax Credit Deferrals:

• Bunch itemized deductions into 2013 and take the standard deduction into 2012.  Note, however, the AGI limitation rises to 10% in 2013 from the current 7.5% (except for those over age 65), so this limitation may dictate the opposite strategy in certain taxpayer situations.
• Postpone paying certain tax-deductible bills until 2013.
• Pay last state estimated tax installment in 2013.
• Postpone economic performance until 2013 if you are an accrual basis taxpayer.
• Watch adjusted gross income (“AGI”)  limitations on deductions/credits.  For certain expenses such as elective surgery, dental work, eye exams, it would be better to have it done in the year that you are already above the applicable  AGI  threshold.  However, it may be better to incur these expenses in 2012 where the applicable AGI limit (7.5%) is lower than the 2013 limit (10 % for those under 65).  It all depends on the particular tax situation of each taxpayer.
• As mentioned above, watch the AMT. Missing the impact of the AMT can make certain year-end strategies counterproductive. For example, aligning certain income and deductions to cut regular tax liability may in fact increase AMT liability.  It is very easy to have your tax planning backfire by missing the difference between the regular tax and AMT tax rules.

Example: Do not prepay state and local income taxes or property taxes if subject to the AMT.  It will generate no income tax benefit.

• Watch net investment interest restrictions.
• Match passive activity income and losses.
• Purchase machinery and equipment before the end of 2012.  The very generous current Section 179 deductions decline in 2013 to $25,000 and there is no 50% bonus depreciation in 2013.

Final Thoughts and Warnings:

Remember that these are some of the customary year-end income tax strategies and are not all-encompassing.  Taxpayers must take into account slated tax law changes for next year and last-minute tax laws enacted before year-end.  Accelerating tax payments must take into account the impact on cash flow and the present value of money.  This is why it is essential to “run the numbers” to find the best steps to reduce the impact of these new tax laws.

Also keep in mind that recent tax law changes, like the 3.8 medicare tax that applies to 2013, bear heavily on income tax planning.  For more details please read 2013 Sneaky New Tax – Not Too Early to Plan for 3.8 % Medicare Tax on Investment Income.

Most importantly remember that income tax strategies depend on the specific income or expenses of each taxpayer and their overall income, gift and estate tax setting.  This discussion offers some but not all tax strategies.

As always, it is quite beneficial to have tax counsel look at the details of your particular income tax situation to carve out specific tax strategies to cut taxes owed.

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IRS Slams Taxpayers: Attention to Tax Details Matter

Taxpayers found out the hard way that the documentation rules imposed by the IRS better be followed exactly and to the letter.  In Durden, TC Memo, 2012-140, taxpayers claimed a $22,517 charitable contribution for 2007.  The IRS disallowed this deduction and the United States Tax Court agreed.

The taxpayers had canceled checks and a letter dated January 10, 2008 from the church confirming this contribution.  Seems like that would be enough.  Wrong!

The IRS did not accept the church’s acknowledgement because it lacked certain language as required under IRS rules.  For a charitable contribution deduction, Section 170(f)(8) of the Internal Revenue Code requires that a monetary contribution of $250 or more must be substantiated by:

1. A contemporaneous written acknowledgment,
2. That indicates the amount paid by the taxpayer, and
3. Whether the organization provided any goods and services in consideration (or in exchange) for the contribution, and if so, a good faith estimate of the value of such goods and services.

The problem for the taxpayers was that the church failed to include part 3 in their January 10, 2008 letter to the taxpayers.  They then went back to the church and got a second letter dated January 21, 2009 that revised the first letter by containing the required language under part 3 of this test.

But now the problem was that the revised letter was too late so it could not be considered contemporaneous by the IRS.  To be contemporaneous under Section 170(f)(8)(C) of the Internal Revenue Code it must be obtained by the due date of the tax return (here April 15, 2008) plus any extensions or, if earlier, the date the taxpayer files the return.  So now the taxpayers flunked part 1 of the test!

You might think that this is pretty harsh since the taxpayer’s really came close here.  So did the taxpayers.  The taxpayers argued that since they substantially complied they should still get the deduction.  The substantial compliance test has been successfully argued where a taxpayer can show that despite strict compliance they have met the essential statutory purpose of such requirement.  The court pointed out that the essential statutory purpose of the acknowledgement rules are  two-fold:

1. Assist taxpayers in determining their deduction, and
2. To aid the IRS in processing returns.

The court determined that without a statement from the church that no goods and services were provided,  neither of these two essential statutory purposes can be met.

This is a pretty harsh result for the taxpayers, especially since it was clearly the church that failed to provide the requisite language.  But the object lessons here are clear.

First, when dealing with charitable contributions you better make sure this language is present, especially in cases where large gifts are involved.

Second, when it comes to taxes attention to details is essential.

Third and finally, complying with the various federal, state and local income taxes is complicated.  Having an attention-to-detail minded tax attorney, or tax accountant is greatly recommended and probably essential.  With the loss of this large charitable deduction and the cost to bring this matter before the United States Tax Court, the Durdens definitely found this out the hard way.

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New 2013 Medicare Tax: 3.8% Stealth Tax

The Supreme Court has recently ruled that the new health care act is constitutional.  As a result, on January 1, 2013, as part of this health care law, the new 3.8% medicare tax will start to impact many taxpayers.  It would seem prudent for taxpayers to plan now for this new stealth tax.   Basically, this new extra 3.8% tax applies to the lesser of

1. Net investment income or
2. The excess of modified adjusted gross income (MAGI) over the “threshold amount.”

Threshold Amount: The threshold amounts are dependent on the type of taxpayer.  Here are the threshold amounts for various taxpayers:

1. For married taxpayers filing jointly, the threshold amount is $250,000
2. Married filing separately, the threshold amount is $125,000
3. All other individual taxpayers, the threshold amount is $200,000.
4. For trusts and estates, the threshold amount is $11,650.

This is just a basic overview.  To learn more about this stealth tax please read 2013 SNEAKY NEW TAX:  Not Too Early to Plan For The 3.8 Percent Medicare Tax On Investment Income.  This article provides more details about this tax, its scope, limitations and exclusions.  The article also provides examples of how this tax operates.

With 2013 quickly approaching, it is not too soon to become aware of this new stealth tax and look at methods to possibly lessen the impact of this tax.

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Summer Camp: Tax Breaks For Those Working or Looking For Work

Now that the summer is in full bloom, parents who have sent or considering sending their children to summer camps may not be aware of the tax implications.  Parents who have placed children in camp while they are working or looking for work may be eligible for various tax breaks such as the dependent care credit  and the deduction for medical expenses in certain special situations.  To get a better grasp of the various tax breaks and the special rules and limitations in this area readers should explore Summer Camp: Tax Treatment.

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