√ Surtax/Kiddie Tax Planning
The 3.8% Surtax may be avoided by distributions to children subject to the Kiddie Tax (persons under age 19 and full-time students under age 24 with unearned income over $2,000 for 2013) will be taxed at the parent’s tax rate. However, each child’s AGI is viewed separately from the parent’s AGI for purposes of testing whether the Medicare tax on passive income applies. IRC Sec. 1411. If the child’s AGI is under $200,000 the child will not be subject to the Medicare tax. For this tip to succeed a separate income tax return must be filed for the child. Do not report the child’s unearned income on the parent’s income tax return. If the child’s unearned income is reported on the parent’s return, the parent’s MAGI will be considered and the Surtax may apply. The challenge with this planning is the risks of putting significant income in a child’s hands to save a 3.8% tax.
√ Self-Referential Exception
The self-rental exception for the net investment income tax (NIIT) can be illustrated as follows. A manufacturer has interests in FLP that rents building to her dental practice. The self-rental exception to the IRC Sec. 469 passive loss rules applies and the income in the FLP from the rental to the professional practice is deemed active. This characterization also avoids the NIIT 1411 Surtax. Estate planning may bifurcate ownership tainting the self-rental exception. For example, the dentist may transfer her interests in the FLP owning the practice building to trusts for her children. If those trusts are grantor trusts they will be ignored for income tax purposes and the manufacturer will continue to be treated as subject to the self-rental exception. However, if the grantor trust status of those trusts is turned off (by an action to avoid the settlor/manufacturer continuing to be taxed on the income, the death of the settlor, etc.) the trust will be respected and the identity of ownership of the manufacturer and the rental FLP will be broken. The self-rental exception will no longer apply and the NIIT Surtax will apply. This can be a challenge to continue to avoid the NIIT. What can be done? Shift interests to requalify by having trusts sell interests.
[This article is course content for the Tax Season 2016 CPE quiz, worth 3 CPE credits! Reach the quiz and additional content HERE.]
√ Gifts Under a Power of Attorney
Powers of attorney, which authorize an agent to act when the client is unable to do so, are an essential estate planning document. Most powers of attorney include a provision authorizing the agent to make gifts almost always up to the annual exclusion amount. In 2015 this amount is $14,000. For clients that face either a state or federal estate tax a gift provision can be quite valuable. Even for clients not subject to any transfer tax concerns a gift provision may be valuable to enable the agent to help support family members the client has helped out. The challenge with a gift provision is how to minimize the risk that the agent will abuse the power to enrich himself or herself. Elder abuse is rampant. Is the potential benefit of such a provision worth the risk? What can be done to protect the client from this risk? The challenge of a tax oriented gift power, is much more difficult than mere tax planning.
√ Credit Shelter Trusts
Traditional estate planning has often been based on distributing assets on the death of the first spouse to a credit shelter trust. These assets would be available to the surviving spouse but not included in his or her estate. The problem using credit shelter trust is that the assets excluded from the survivor’s estate will not receive a basis step up on the survivor’s death. The simple and inexpensive solution to this is to bequeath assets out right and rely on portability and the inflation adjusted exemption to avoid estate tax on the surviving spouse’s death. The problem is that the option of an outright bequest is certainly simpler, less costly and might result in a better overall tax result. However the challenge to that tax planning is that should the surviving spouse remarry, prove fiscally irresponsible or be sued all of the assets the credit shelter trust could have protected might be lost.
√ 754 Basis Adjustment
The tax focus of estate planning for all estates, taxable or smaller, has shifted to increase income tax basis by having appreciated assets included in the decedent’s estate. When a limited partnership or LLC taxed as a partnership is included in the decedent’s estate a Code Section 754 basis adjustment must be made by the entity in order for the increase in the tax basis to be effective. The challenge with this oft assumed tax result is that the managing member of the LLC or the general partner of the partnership may not be willing to make a 754 election. The challenge to practitioners will be to convince clients that are able to, to negotiate provisions in current partnership and operating agreements to mandate that a 754 election has to be made.
√ Minimizing State Estate Tax
Many states that have decoupled from the federal estate tax system can present costly estate taxes to a client’s estate. The only state which has a gift tax is Connecticut (although New York effectively has an estate tax as part of his re-coupling with the federal estate tax). Thus, it may be feasible for a client to gift assets thereby removing them from the reach of his or her state estate tax. The challenge for many clients is that while they are desirous of saving state estate tax they are worried and uncomfortable about losing access to their assets. There is a way to have these clients can have their tax cake and eat it too. The gifts can be made to a self-settled irrevocable trust (often referred to as a domestic asset protection trust). The client can be a beneficiary of such a trust, yet the trust can be treated as a completed gift and removed from the client’s estate. The challenge is that this type of planning can be costly and complex. For example, if the client does not reside in one of the 15 states that permit self-settled trusts the client will likely have to name a corporate trustee in one of those states to create nexus to one of those states that permit self-settled trusts. That will require annual trustee fees in addition to other costs. Even if the state estate tax savings can be significant, as the costs of the planning grows it becomes a challenge to get the client comfortable with proceeding.
√ Surtax S Corporation Planning
QTIP (marital) trusts owning S corporation stock have typically elected Qualified Subchapter S Trust (QSST) treatment. Is a QSST the optimal result for Surtax planning? With a QSST all S corporation income will be reported by the surviving spouse and the surviving spouse will be the touchstone for determining material participation. Will the surviving spouse materially participate? Perhaps an electing small business trust (ESBT) a better result? If an ESBT is elected the trust pays all income tax on s corporation income and the trustee, instead of the surviving spouse, becomes the touchstone for determining material participation. The challenge with this approach is that the maximum tax bracket on all trust income.
√ Executor Responsibility to Report
As a result of recent law changes, the executor or personal representative must provide information to each beneficiary as to the basis of assets distributed. New IRC Sec. 6035, “Basis Information To Persons Acquiring Property From Decedent.” How should this be done is quite a challenge. In the past, few executors had sent an estate tax return, Form 706, to any beneficiary. While some executors might be tempted to send a copy of the entire return to each beneficiary to meet whatever disclosure obligation the IRS imposes that level of disclosure may prove a significant mistake. That much information in the hands of each beneficiary might result in the executor being inundated with questions about valuation, dispositions and anything else on the estate tax return. It might prove less problematic to have a schedule prepared for each beneficiary providing details as to the assets bequeathed to that particular beneficiary. This, however, will create more administrative costs and professional fees which executors might object to when they don’t not perceive a tax savings from the incremental efforts. Executors will be required to report basis information to beneficiaries within 30 days after the due date of the estate tax return, or from the date the return is actually filed. A practical problem with this reporting is that if the executor is given discretion as to how to divide assets among different beneficiaries, that decision may not have been made by the reporting deadline. In the past, it didn’t not matter, now it may.
Martin M. Shenkman is the author of 35 books and 700 tax related articles. He has been quoted in The Wall Street Journal, Fortune, and The New York Times. He received his BS from the Wharton School of Pennsylvania, his MBA from the University of Michigan, and his law degree from Fordham University.
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