Estate planning is often viewed as independent of income tax compliance, and vice versa. The reality is that properly crafted estate planning will have to be reflected in many ways on the client’s income tax return for that planning to succeed. Practitioners who are alert to the income tax reflections of estate planning techniques will be in a better position to assure that those techniques are properly carried through from both an estate planning as well as an income tax compliance perspective. The following are some of the many income tax ramifications of a client’s estate planning that practitioners should consider:
√ Family Loans
With continued historically low interest rates, intra-family loans remain a popular wealth-shifting device. A parent, for example, can loan a large sum to a child, who can invest the money to grow his or her estate. The parent can charge the minimum current interest rate under IRC Sec. 7872 and avoid any of the interest imputation, gift and other consequences.
Family loans are also common as parents and other benefactors endeavor to help future heirs cope with economic challenges. For these common family loans to be respected a number of criteria should be met:
There should be a written loan document (e.g., a signed promissory note). Practitioners should hold a copy in the client’s permanent file.
The parent/lender should charge interest and the child/borrower should make payments as required under the loan documents. The interest income should be reflected on the parent’s tax return you prepare. If you also prepare the child’s income tax return the interest expense should be reflected if deductible. If the loan was to help the child purchase a home, be certain to obtain a copy of the mortgage that was recorded corroborating that the interest expense qualifies as home mortgage interest.
Confirm that the interest income/ expenses are consistent with terms of the note. If not it might indicate that a payment was missed, some of the loan forgiven, or other issues that you need to address to assure that the loan is respected for tax purposes.
√ Reasonable Compensation Issues
Practitioners are commonly aware of the issues relating to “reasonable” compensation when preparing an S corporation return considering David E. Watson, P.C., 714 F. Supp. 2d 954 (S.D. Iowa 2010). Some clients try to push the envelope of unreasonably low compensation to save on payroll taxes:
IRC Sec. 1402(a). The flip side of the S corporation tax coin is the compensation reporting on the shareholders’ personal Form 1040. But S corporation distributions to save payroll taxes is only the tip of the reasonable compensation iceberg. There are a host of critical estate planning issues that might be affected (in many cases undermined entirely) if the individual client’s compensation is not reasonable. Much like the story of the porridge and the three bears, if it is too large or too small, estate tax problems could result. The temperature of the porridge, and the amount of the compensation, has to be just right.
If an individual client is reporting compensation that is unreasonably high, that might imply that the client has retained an interest in the family limited partnership, S corporation or other entity, part of which was given by gift to heirs. A common estate planning technique was and remains to gift stock in the family business entity to heirs using the annual gift exclusion, presently $13,000. But over the years as the percentage interest owned by the heirs increases, if the parent continues to take all or the lion’s share of the earnings as compensation, the IRS may well argue that the parent has retained an income interest in the corporation. The net result is the IRS arguing that the entire value of the corporation is included in the parent’s estate: IRS Sec. 2036.
Even if the client is not concerned about estate tax, the potential for a reversion to a much lower federal estate tax exemption, and the creditor protection of the completed gifts, could all prove problematic.
If the client has made prior gifts to grantor retained annuity trusts (“GRATs”) of interests in the business, taking an unreasonably low compensation could be tantamount to the client making an additional gift to the GRATs. That is impermissible and could unravel the entire estate plan.
Reasonable compensation can raise issues that affect any estate or asset protection plan a client may have. Practitioners reviewing personal returns need to consider the broad implications of the compensation issue, not just the unreasonably low compensation in an S corporation context.
√ Grantor Trusts
Grantor trusts have become one of the most popular asset protection and estate planning techniques. When a client transfers assets to an irrevocable trust, it is common to include in the trust provisions that characterize it as a grantor trust, the income of which is taxable to the client. The payment of income tax on income that remains inside an irrevocable trust is a powerful method of reducing remaining assets that would otherwise be exposed to creditors or estate taxes.
Another common grantor trust is the ubiquitous revocable living trust. While often used to avoid probate, living trusts are often used to segregate inherited or gift assets that may be immune from equitable distribution in a divorce proceeding. How these grantor trusts are handled on the client’s Form 1040 could be critical to the success of vital client planning.
If the client’s parent or other benefactor established the trust and the trust included an annual demand or Crummey power for the child/ beneficiary, the trust might be a grantor trust as to the child, not the parent. This technique, known as a Beneficiary Defective Irrevocable Trust (BDIT), has to be handled quite differently than the more traditional grantor trust (e.g., a domestic asset protection trust or dynasty trust) a client establishes with the client as the settlor (setting up the trust) and taxed as the grantor. Reporting the income on the wrong client Form 1040 could undermine the planning.
In the case of a revocable living trust that was intended to preserve the immunity of assets the client received as a gift or inheritance, if the income tax attributable to that trust’s assets are paid out of marital funds, the integrity of those assets as immune in a future divorce could be compromised. A number of variations of grantor trusts, each with its own unique nuances, and improper treatment for tax reporting could undermine a much more significant plan.
√ Insurance Transfer for Value Rules
Clients universally assume life insurance proceeds are income tax free. While this might often be true, there is a significant exception to this generalization. If an insurance transfer runs afoul of the transfer for value rules the proceeds might be subject to income tax. IRC Sec.101(a)(2).
The rules are not logical and caution is always in order. If a corporation distributes insurance to a shareholder, the transfer for value rules might be triggered. However, a transfer from a partnership to a partner does not trigger the transfer for value rules. Any transfer of life insurance that appears on any return should be investigated to assure that the transfer for value rules are not triggered.
√ Entity Distributions
While quite simplistic, distributions from entities too often don’t match the underlying legal documentation. For example, a parent has given annual gifts of stock in a closely held family S corporation or FLP for three years to four children. The distributions should be in proportion to the equity interests held by each equity owner. Far too often the ownership percentages on the Forms K-1 are not consistent with the ownership interests reflected in the underlying legal documents (e.g., stock certificates for a corporation, operating agreement for an LLC, etc.).
Practitioners should be certain to confirm K-1 percentages to governing documents in their permanent file for the entity. If the documents are current, copies have not been provided, or the percentages differ, the client should be advised to follow up with his or her attorney. If practitioners file income tax returns corroborating disproportionate distributions those returns could be the support cited by a creditor or IRS auditor looking to pierce the entity or undermine a client planning transaction.
√ Schedule C Disregarded LLCs
Clients often favor the use of single member disregarded LLCs so that the cost and administrative burdens of a partnership return Form 1065 can be avoided. The downside to this is that in the event of a lawsuit the client’s personal Form 1040 may be open to investigation since that is the return on which the income is reported. It could be far preferable to have a multimember entity and file a Form 1065. In the event of a lawsuit or other challenge, only the entity’s Form 1065, not the client’s personal return, may be discoverable.
√ Schedule B and Title to Assets
In spite of the 2010 Tax Act’s enactment of portability, which supposedly permits the surviving spouse to utilize the unused estate tax exemption of the first to die, most estate planning practitioners still generally prefer to use the more traditional estate planning technique of funding a bypass trust on the death of the first spouse. There are simply too many risks and unknowns to rely on portability of a bypass trust.
For many clients dividing nonretirement investment assets (e.g. brokerage accounts) so that each spouse has adequate assets to fund a bypass trust on death (and for many clients it is not the federal exemption amount that will need to be funded but the lesser state estate tax exemption amount in a decoupled state.
When preparing Schedule B, practitioners should be alert to how asset ownership is divided and if the 1099s indicate that a predominance of assets are in the name of one spouse, the issue should be raised.
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