Introduction
SALY (same as last year) can be a recipe for disaster if you don’t verify the current state of facts. The American Taxpayer Relief Act of 2012 (ATRA) has dramatically, and forever, changed the face of estate planning. Practitioners are no doubt familiar with the key changes (permanent $5 million inflation adjusted exemption, permanent portability, higher income tax rates) the effects of ATRA have been compounded by the new 3.8% Medicare tax on passive investment income. How does all of this affect compliance and related practices for the CPA? The planning tips below focus solely on estate and related planning matters, but are presented by the tax returns they affect. CPAs often use tax returns as the starting point to identify tax issues, and identifying estate planning opportunities for clients can be viewed in the same way.
Form 1040 Individual Income Tax Returns
√ Itemized Deductions: In light of the new phase out of itemized deductions carefully review which taxpayer (client individually, family LP or LLC, or trust) can or should pay for various investment, legal and other expenses.
√ Defined Valuation Clauses: See the comments below concerning defined value clauses and consider whether a disclosure statement should be attached to the income tax return for the client. This may be advisable when the income tax return reflects the income from various grantor trust Forms 1041 which were party to defined value clause transactions.
√ Grantor Trusts: See the comments below concerning proper determination of grantor trust status. Do not assume based on SALY (same as last year) what the character of a trust is if you have not confirmed it.
√ Tax Reimbursement Clauses: Some trusts include a provision that permits the trustee to reimburse the client/grantor for income taxes the client has paid on income earned by a grantor trust. Be certain to review the clause, and involve the drafting attorney if you feel it necessary, before making any calculation of the amount of tax that can be reimbursed. Some trusts have specific formulas or criteria for how this should be calculated. Also, caution the client that regular ongoing reimbursement of all taxes may be argued by the IRS to indicate an implied agreement between the client and the trustee as to the client/grantor’s continued interest or retained power over the trust. Also, be certain that the state that governs the trust permits this type of clause. Trust friendly states like Delaware do, but many states do not and the inclusion of such a clause would expose the trust assets to the reach of the client’s creditors and cause inclusion in the client’s estate. If this risk exists be certain to involve counsel as steps might be taken, like decanting the trust (pouring over the old defective trust into a new improved trust) to address the issue.
√ Schedule B and Bank Accounts: Many clients set up Spousal Lifetime Access Trusts (SLATs) for estate planning. Example: Wife sets up a trust for husband and all descendants. Be certain that the husband in this scenario has his own bank account to which distributions from the SLAT can be made to him. If husband were to deposit trust distributions from a SLAT into a joint account it would appear that wife has retained control over the distributions of a trust she formed. This could undermine all estate and asset protection objectives for the trust.
√ Life Insurance: Evaluate, or have the client’s investment and insurance consultants evaluate, the potential benefits of the tax free build up of investment value inside a permanent life insurance policy in light of the new higher income tax rates and the 3.8% Medicare tax on passive investment income. Many clients only view insurance from an estate planning perspective but the changes of ATRA may make the income tax benefits more important.
Form 709 Gift Tax Returns
√ Extend: 2012 will be the most challenging gift tax return season CPAs will ever face. Most returns will be extended (and should have been) given the sheer dollars involved and the complexity. Use extensions to provide adequate time to address the unique complexity and reporting positions that you will need to disclose.
√ Identify All Gifts: 2012 was a unique year in estate planning history. Never before have so many gifts been consummated, and many were completed in the last few months of the year. The turmoil and pressure of completing these gifts may result in a host of complications. Confirm with the client, the client’s estate planner, trust officer, financial planner and insurance consultant whether each of them is aware of any gifts. Unlike prior years don’t assume the client or their estate planning attorney is aware of every gift. Many might not be. Clients may have made last minute transfers to get gifts in under the possible 2013 changes that no one else knows about. 2012 was also unique because of the incredible time pressure involved.
√ Trust Funding Tranches: In most years when a client makes transfers to a trust, the trust is completed, the advisers plan the gifts or sales and the transactions are consummated. Unlike any other year in history many estate planners had clients fund trusts in tranches. An initial gift might have been made. Again, unlike all prior years, many of these initial gifts may have been large dollar amounts, not just the nominal $100 used historically to fund an initial gift to a trust. Some time later, when an appraisal was completed or other approvals received, interests in a business may have been transferred to the trust. In 2012 it was not unusual for a trust to have three or more separate transfers. Be certain to identify all of them.
√ Appraisals: Many 2012 gifts were made with estimates not final appraisal reports. Be certain to obtain final appraisals and not erroneously file with a draft or preliminary report. Also, check all the numbers before filing; in the haste to complete appraisals lots of points may have been missed. Example, if a couple each made a gift of a one-half tenants in common interest in their residence to Qualified Personal Residence Trusts (QPRTs) the discounts available on these interests are often overlooked by real estate appraisers and if a separate discount appraisal was not received it may not have been addressed. Be certain to compare the final appraisals to the preliminary estimates and if there are differences discuss them with the client and advisory team before filing.
√ Adequate Disclosure: To run the statute of limitations for gift tax audit purposes you must disclose sufficient information in the gift tax return attachments. Be certain to review the regulations and be sure to address every required item. Do not assume that what the client’s attorney or wealth manager sent you is sufficient. It often is not. It is your responsibility to seek out this information.
Form 1041 Trust Tax Returns
√ Understand the Trust: You cannot file a trust unless you are clear as to the appropriate income tax status for the trust. The name of the trust or the client’s comments are rarely sufficient to rely upon. In most cases the smartest approach is a two-pronged approach. Directly ask the attorney who prepared the trust what the intended income tax status was to be. Regardless of the reply, note it, then review the trust document and be certain you concur. If you don’t feel anyone in your practice has the capability to read a complex trust and properly identify its status, insist that the client permit you to meet once with the attorney who prepared the trust to review the document with the draft-person. Having the correct current classification and being aware of how and when that might change are vital to your properly meeting your compliance responsibilities.
√ Reciprocal Trust Doctrine: This tax doctrine can permit the IRS to unwind related trusts if the provisions are too similar. This is a particularly common risk where each spouse or partner set up a similar trust for the other. These are sometimes called Spousal Lifetime Access Trusts (SLATs) but often are not identified by name. If you have similar 1041s for trusts (for a couple) raise the issue and recommend that a post-tax season meeting be held with the attorney and investment adviser to determine what steps can be taken to further differentiate the trusts. It is not always enough that the trusts were drafted by the attorney with some legal differences; the manner in which they are operated could be important to that determination as well. Much of this data as to how they are operated will appear in the trust income tax returns you are preparing.
√ Valuation Adjustment Clauses: Many gifts and sales to trusts were planned to include valuation adjustment clauses. These can be illustrated quite simply for those readers not familiar with the concept. Example: Client owns 100% of the stock in a family S corporation. 40 shares, or 40% of the stock, net of discounts for lack of marketability and control are valued at $5 million. If the IRS successfully audited the gift and demonstrated the value was $7 million a gift tax of over $700,000 would be due. If instead the client gave $5 million of shares, with the number of shares, not the value to be determined on audit, arguably no taxable gift would be made. While this illustrates only one type of defined value clause, whatever type is used presents particular compliance issues for CPAs. Consider attaching a disclosure statement to every tax return (gift and income) indicating that a defined value clause was used. For example, attach to the Form 1120S K-1 for the above example a statement indicating that while the K-1 indicates figures based on 40 shares of stock that the actual number of shares is merely an estimate and that the final number will be determined based on a defined value clause. If this is not done, the manner of reporting the transactions may contradict the intent of the defined value clause.
√ Grantor Trust: Many, but far from all, sophisticated gift trusts were set up as grantor trusts. While many clients may have appreciated this in theory, issues may arise over time as clients are called upon to write out large estimated or balance due tax checks while the funds are being held in a trust and not their personal account. Coordinate this in advance with clients. Also, as discussed elsewhere in this article, confirm that the trust is in fact a grantor trust and that the mechanism to create that income tax status remains in force. Example: If a trust is set up as a grantor trust because the client/grantor was given a right to substitute property, but after execution the client signed a separate document waiving that right, the trust may no longer be a grantor trust. You cannot be assured of the current income tax status of any trust without confirming what, if any, actions were taken after the trust was established by the grantor, trustee or perhaps other persons.
√ Old Bypass Trusts: Many clients have bypass (also known as credit shelter trusts or by other names) trusts that were established on the death of their spouse. While those trusts may have made sense when the federal estate tax exemption was much lower, they may no longer be necessary in some cases. Worse, in some cases there may no longer be any federal estate tax savings generated by the trust, but retaining assets in the trust may prevent a step up in income tax basis on the death of the second spouse. And all this while the client is paying for a tax return and enduring additional complexity. If you’re completing the 1041 for such a trust, and you are certain that the combined estate of the surviving spouse and the bypass will be under the federal exemption, raise the issue in a letter to the client. Depending on how the bypass trust was drafted (a decision the client’s lawyer can address) it may be as simple as distributing the assets to the spouse and ending the trust. In other cases ending the trust may not be possible but better investment planning can minimize the tax negatives. Also consider state estate tax if the client is in a decoupled state (and has a separate estate exclusion amount).
√ S Corporations: Be very careful that only a Grantor Trust, Electing Small Business Trust or Qualified subchapter S Corporation Trust (QSST) can own stock in an S corporation. If S corporation stock is held in a trust be certain that you have carefully verified that one of these requirements are met. If the trust is a grantor trust, be very mindful that on the death of the client, or the relinquishment of certain powers (e.g., the right for someone to loan funds to the client/grantor without adequate security, the right to add a charitable or other beneficiary, or the grantor’s right to swap assets) are terminated, grantor trust status will end and that trust will no longer be permitted to own S corporation stock unless an affirmative ESBT or QSST election is filed. Do not file any trust income tax return in any year without confirming for that year that the above issues have been properly addressed.
706 Estate Tax Returns
√ Portability Returns: In order to qualify a surviving spouse to use the “first to die” spouses unused estate tax exemption, the Deceased Spouse Unused Exemption (DSUE) a federal estate tax return has to be filed for that “first to die” spouse’s estate. Where many estate planning attorneys traditionally prepared these forms, CPA firms may be able to do so more cost effectively. Given that the vast majority of estate tax returns will be filed for this purpose, will have no tax due, and can rely on simplifying estimates, this may be a lucrative practice area for CPAs.
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