The debate is raging in Washington over how to solve the deficit problem. Lots of our representatives believe that a tax increase is inevitable. From a philosophical perspective, it’s hard to argue that there’s a tax more clearly associated with “the rich ” than estate taxes.

The federal estate tax exemption—the amount that can be passed to kids without having to worry about estate taxes—for calendar years 2011 and 2012 is scheduled to be $5 million for a single person. For a married couple the exemption can be $10 million. The tax rate on the estate in excess of those amounts is a flat 35 percent.

If Congress and the President do nothing prior to the end of 2012, at the beginning of 2013 the exemption amount is scheduled to drop to $1 million, and the top estate tax rate will be 55 percent.

The IRS published statistics a few months ago about federal estate tax returns filed for those who passed away in 2007. What do the statistics tell us about estate taxes then and now?

• Whether the exemption amount ends up being $1 million, $3.5 million, or $5 million, it shouldn’t make a difference of more than about 25 percent in the amount of estate taxes collected for a given year.

• Annual estate tax collections are not a big revenue number, relatively speaking, for the federal government. They represent about 2 percent of the budget deficit, and .2 percent of the national debt.

• A smaller estate tax exemption will probably disproportionately affect the survival of family farms unless special protections are built in.

• A smaller estate tax exemption will probably not disproportionately hurt closely held businesses.

Do these observations provide any assurance about what will happen with federal estate taxes? Unfortunately, no. Feel welcome to keep in touch with me so you can stay in touch with the latest federal estate tax developments.

If you feel your estate plan is not up-to-date or needs a review, please contact us.

AS ALWAYS, PLEASE FEEL FREE TO CALL TO DISCUSS THESE OR OTHER FINANCIAL SECURITY ISSUES OF CONCERN.

Subchapter S of the Internal Revenue Code allows the shareholders of an eligible small-business corporation to make an election to tax the corporation as a pass-through entity, an S corp, thereby avoiding the double taxation of income inherent in regular C corporation income.

For example, a C corp pays tax on its income at the entity level, then the shareholders pay tax on the income again when it’s paid out as dividends.  An S corp, though, typically does not pay tax at the entity level, but taxable income is reportable on the individual shareholders’ tax returns directly–thereby bypassing the entity-level tax.  This is a tremendous break for the shareholders, and it’s critical that executors and advisers handle S corps appropriately and protect the S election status.

Tax reporting in the Year of Death

 S corp income is prorated on a per-share-per-day basis among shareholders.  When a shareholder dies, income allocable to that person’s shares is prorated between the individual tax return and the estate.  Alernatively, if all affected shareholders agree, the books may be closed at the date of death and pre-death and post-death income allocated among shareholders accordingly.

An analysis of the impact of this election will need to be done in time for filing any affected tax returns, and may impact shareholders’ current year estimated tax payments.

Tax Basis of Inherited Stock 

Following normal tax rules, S corp stock held as the separate property of the decedent will receive a Sec. 1014 step-up in basis to date-of-death or alternate-valuation-date fair market value.  Stock held as community property will also receive a basis step-up as to both the decendent’s and surviving spouse’s community property shares.  For 2010 deaths only an election out of the estate tax regime to modified carryover basis treatment is available, in which case a new set of laws will apply that are beyond the scope of this article.

If S corp stock was used to fund a marital trust or bypass trust at the death of the first spouse, then care should be taken at the second death because only the stock owned by the marital trust will receive a stepped-up basis at the second death.  Stock held in a bypass trust will not receive another step-up at the death of the surviving spouse.

Suspended Losses, Tax Basis Limitations

Generally, S corp losses suspended by tax-basis limitations are personal to the shareholder and cannot be transferred to another person [Reg 1.1366-2(a)(5)].  Thus, suspended losses on stock held by the decedent at death are permanently disallowed to beneficiaries of the stock.

Income in Respect of a Decedent

The stepped-up basis of S corp stock is reduced by the amount of the stock’s fair market value that is attributable to items of income in respect of the decedent (IRD) [Sec. 1367(b)(4)(B)].

For example, if a cash basis S corp held uncollected accounts receivable at the date of death (or applicable alternative valuation date) that would have been treated as IRD if held directly by the decedent, then the basis of the inherited stock is reduced by the IRD amount.  When the coporation receives the accounts receivable payments and the income is reported to the stock beneficiaries, the  stock basis is increased by the amount of the pass-through income.  To the extent any estate taxes were paid by the decendent’s estate, the beneficiaries would be entitled to deduct on their own tax returns the portion of the estate taxes attributable to the IRD.

Postmortem Article published August 2011

Article reprinted with permission from the California Society of CPAs. Unless otherwise stated, views expressed are those of the authors and individuals quoted, not CalCPA.

In 2011, after EGTRRA’s sunset, the transfer tax rules are scheduled to revert back to pre-EGTRRA status ($1 million exemption and maximum 55 percent tax rate for gift, estate and GST taxes).

Although practitioners believed Congress would act well before EGTRRA’s sunset date and change the 2010 estate laws, other pressing issues, including the nationwide economic woes and health care reform, have so far stolen the legislative spotlight and no changes to the status quo have been enacted.

Thus, if Congress does not reinstate or modify the estate and gift tax rules for 2010—either retroactively or prospectively—the current scheme of no estate taxes, no GST taxes and a gift tax rate of 35 percent will apply in 2010. Assets inherited from 2010 decedents will pass to beneficiaries under a set of new modified carryover basis rules under IRC Sec. 1022 instead of the familiar stepped-up basis rules of IRC Sec. 1014.

Modified Carryover Basis

The modified carryover basis rules provide for a $1.3 million step-up in tax basis over the decedent’s tax basis, up to the fair market value at the date of death, for the assets of decedents dying in 2010 (the aggregate basis increase), plus an additional $3 million step-up for assets passing to a surviving spouse. Additional increases also may be available for a decedent’s unused capital loss and net operating loss carryovers and certain built-in losses. Both halves of community property assets owned by the decedent qualify for allocation of the aggregate basis and the spousal basis increases.

Reporting Requirements

No estate tax returns will be required. Instead, the executor of a 2010 decedent’s estate must allocate the available basis increases among the decedent’s assets. For estates with a total asset value (other than cash) exceeding the $1.3 million aggregate basis increase, the allocation must be reported to the IRS on an as-yet unreleased form. Gift tax returns will still be required for gifts to any one individual in excess of the $13,000 annual exclusion.

New Risks and Responsibilities

The administration of the estates of 2010 decedents under these new rules will therefore be especially challenging. Everyone involved— including fiduciaries, attorneys and accountant advisers—will have the additional responsibility and related risks of allocating the new aggregate basis increase and the additional spousal basis increase among assets hence among beneficiaries receiving those assets. Additionally, actions taken before death can significantly impact the post-death options available, and may even increase the aggregate basis increase amount.

Planning Considerations

Following is a summary of pre- and post-death planning issues and considerations. Practitioners will want to review the 2010 rules with an eye to identifying key points and action items, keeping in mind that all could change by an act of Congress. More than ever it will be important to continue monitoring pending legislation in this area.

Pre-death Planning

• Review asset allocation formula clauses in the governing documents to determine if the absence of estate and GST taxes in 2010 adversely impacts the intentions of the client in determining who gets how much of the estate.
• Consider that the $1.3 million aggregate basis step-up is not allocable to a qualified terminable interest trust assets upon the death of the surviving spouse.
• Similarly, consider that power of appointment assets are not eligible for the aggregate basis increase.
• Think about selling loss assets before death to preserve the losses for allocation as additional basis increases. Loss assets will have a fair market value basis in the hands of beneficiaries, so potential income tax deductible losses and increased basis adjustments will be forgone if the assets are not sold before death.
• Consider having client add language to the will or governing documents outlining what factors to consider in allocating the aggregate and spousal basis increases in light of the fiduciary’s duty of fair and impartial treatment between beneficiaries.
• Determine if the decedent holds any negative basis assets (i.e., debt in excess of basis), and which beneficiaries will receive them. This will impact eventual aggregate basis allocation to mitigate potential gain recognition and eventual asset allocations to beneficiaries.
• Take any necessary steps to mitigate gain if negative basis assets are left to tax-exempt entities.
• Begin gathering tax basis information in preparation for implementing the modified carryover basis rules.
• Begin gathering holding period information.
• Review dispositive provisions for the personal residence, as a residence passing in trust in most cases will not be eligible for the Sec. 121 exclusion of gain on sale.
• Take steps to maximize community property ownership. The decedent’s aggregate and spousal property basis increases can be allocated to both halves of community property.

Post-death Issues

• Consider making the Sec. 645 election for living trusts if distributions of appreciated assets will be made in satisfaction of pecuniary bequests.
• Begin gathering date of death asset valuations.
• Appraisals: Make sure the appraiser notes the appraisal reports are for both carryover basis and estate tax purposes.
• If the gross value of estate assets—except for cash—is more than $1.3 million, a “basis return” in lieu of an estate tax return will be required.
• Negative basis assets: Begin planning for distribution and aggregate basis allocation. Inform beneficiaries who may consider disclaiming, or consider having the estate sell the assets, to share any recognized gains among beneficiaries.
• Remember that a tacked on holding period scheme has replaced automatic, long-term holding periods.
• In allocating the aggregate and spousal basis increases, consider keeping the tax basis less than date of death fair market value to preserve the tacked-on holding period rule.
• Consider potential deductibility of suspended passive activity losses on the decedent’s final tax returns.
• Add net operating loss carryovers to the decedent’s $1.3 million aggregate basis increase.
• Add built-in losses on trade or business property to the decedent’s $1.3 million aggregate basis increase.
• As noted above, add capital loss carryovers to the decedent’s $1.3 million aggregate basis increase.
• Community property: The decedent’s aggregate and spousal property basis increases can be allocated to both halves of community property owned by the decedent at death.

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1. The maximum contribution that can be made to a defined contribution plan in 2010 under Section 415 is the lesser of $49,000 or 100 percent of compensation—the same limit as in 2009.
2. The limit on employee elective deferrals to Section 401K and Section 403b plans has remained at $16,500 in 2010.  The limit for Section 457 plan salary reductions has likewise kept steady at $16,500.
3. The maximum elective deferral for a SIMPLE or 401 K SIMPLE plan is $11,500 in 2010.
4. The limit on IRA contributions remains at $5,000 for 2010.  Those 50 and older can still contribute an extra $1,000 under the special catch-up provision.

Here are a few of the income tax changes:

1. The standard deduction for joint filers and surviving spouses who do not itemize in 2010 is $11,400, the same as 2009.  For heads of household, the deduction is $8,400, and for unmarried individuals it’s $5,700.  The aged and the blind get an additional $1,100 or $1,400 added to their standard deductions, depending on their filing status.
2. The personal exemption has remained steady at $3,650 for 2010.  The exemption started to be phased out at $250,200 of adjusted gross income for married filers, $208,500 for heads of household, $166,800 for unmarried individuals and $125,100 for married individuals filing separate returns in 2009.  The phase-out has been eliminated in 2010
3. The phase-out of itemized deductions began at $83,400 of adjusted gross for married individuals filing separate returns, and $166,800 for all other taxpayers.  The phase-out has been eliminated in 2010.

And here are some other items that may be important to you.

1. The social security tax rate for individuals stays at 7.65% in 2010.  The rate for self-employed individuals also remains constant at 15.3%.  The taxable wage base for the OASDI portion is $106,800 in 2010—and that gets hit with the full 7.65% tax for individuals.  Any additional compensation over that limit is subject to only the Medicare portion of 1.45%.
2. In 2010, the federal annual gift tax exclusion amount has remained at $13,000.  The lifetime gift tax exemption has stayed at $1 million.
3. The federal estate tax exemption was $3.5 million in 2009, and as of right now is scheduled to be unlimited in 2010.  Watch for probable action on federal estate taxes by the Congress and President.  Most experts expect the federal estate tax exemption for 2010 to be reinstated at $3.5 million.

These changes may affect your own retirement or tax plans.

As always, please feel free to call to discuss these or other financial security issues of concern.

Pension plans create income tax deductions for the business, and allow employees to exclude contributions from their taxable income.  However, the employer must include all eligible employees in the plan, and retirement benefits are generally taxable to the participants.

Certain nonqualified benefit arrangements can generally be more selective in terms of participation, but the income tax results are generally not as favorable—especially for the business owners.

Disability income insurance coverage provided by the business can also be selective, and the premium can be deductible.  However, the owner-employee with disability income coverage must generally choose between excluding the premium from income or getting a tax-free benefit in the event of a claim.

Could the best employee benefit be a long-term care insurance (LTCi) plan?

C corporation employers have the greatest number of potential advantages for implementing LTCi plans for their employees.

1. The premium is deductible by the corporation.
2. There is no practical limit to the amount of premium that can be paid by the employer for an employee’s policy.
3. The company can pick the employees to be covered by the plan.
4. The premium paid by the corporation is not included in the employee’s taxable income.
5. The benefits paid to the insured are tax free.
6. Spouse and dependent family members of participating employees may also be included under the plan.

Most of the advantages described are also available to the owners and employees of S corporations, LLCs, partnerships or proprietorships.

For entrepreneurs who have employees nearing retirement, or whose key employees have aging parents, long-term care insurance may be perceived to have high value.  LTCi helps pay for costs associated with chronic illness that, in most cases, Medicare or Medicaid won’t.

The federal government has strongly encouraged business owners to provide LTCi plans to employees, even in some cases if those covered are only the group of owner-employees.  LTCi plans are worth considering by closely-held business owners.

As always, please feel free to call to discuss these or other financial security issues of concern.

Others with IRA balances may be interested in making a tax-free transfer to a new IRA custodian, or in splitting the current IRA account for various reasons.

Tax-free transfers may be made by trustee-to-trustee transfer, direct rollover or 60-day rollover.

We have found that in thinking about transfers, clients want to know:

• Does the account they’re starting with qualify for a tax-free transfer to another qualified account?
• Is the vehicle into which they intend to transfer a qualified plan balance one that can accept a tax-free transfer?
• What administrative procedures need to be followed to accomplish the transfer?
• What special considerations need to be evaluated to help determine whether the proposed transfer makes economic and tax sense?

Rollover distributions from the following plans are eligible for tax-free transfers:

• IRAs
• Qualified pension plans
• Tax-sheltered annuities (403(b) plans)
• Governmental 457(b) plans
• A 403(a) annuity

Rollover distributions can generally be transferred to a traditional IRA or pension plan on a tax-free basis if the pension plan will accept them.

Distributions that might otherwise qualify for a tax-free rollover might be defeated by one or more of the following complications:

• The 20% mandatory withholding on distributions from pension plans may make it difficult for the participant to accomplish a complete rollover of a taxable distribution.
• The prerequisite within a pension plan of a triggering event prior to the distribution of a pension balance may mean that a distribution is not allowed at all.
• The fact that the source of funds intended for rollover is from a beneficiary account rather than the participant’s own IRA may mean rollover is not allowed.
• Multiple IRA rollovers in the same 12-month period may be disallowed by IRS rules.

When done properly, rollovers offer the opportunity to continue tax-deferred growth on  retirement assets.  If done improperly, an attempted rollover may result in a large unexpected income tax result, and cause you to be liable for an extra 10% penalty tax, plus any state penalties.

As always, please feel free to call to discuss these or other financial security issues of concern.

Those considering starting the estate planning process-perhaps by visiting an attorney about a will or trust-usually have one or more questions:

1. Why do I need to prepare a will or trust at all?
2. Do I need a living trust?
3. How can I protect my young children?
4. How can I protect my special needs relative?
5. How do we arrange our affairs to adequately protect all sides of our blended family?
6. How can I keep peace in the family after I’m gone?

What are the answers?

1. Wills or trusts are used to make death-time distribution intentions clear. They are also used to express wishes about guardianship of minor children. A person who dies without a will is said to be intestate. Those who die intestate have an estate plan imposed on them by the state in which they lived at the time of their death.
2. The main reason people choose to do living trusts is to avoid probate. If a person creates a living trust prior to death, and if all the person’s assets are transferred to the trust, probate will likely be avoided at the person’s death.
3. Those who are creating an estate plan are usually interested in making contingency plans for their young children. The contingency plan should cover the logistics and financial aspects of caring for the children. The logistical part of the plan hinges on making the decision regarding who will raise the children—that is, act as guardian—in the event no parent is available to do the job. The financial part of the plan may be to create a trust for children at the time of the death of one or both parents.
4. A special needs trust is designed to ensure that a disabled child or other beneficiary can enjoy the use of trust property, which is intended to be held for their benefit. The trustee of the trust provides management of the trust assets, which the beneficiary may be incapable of. The special needs trust is also usually intended to help the beneficiary avoid losing access to needs-based government benefits.
5. When thinking about estate planning issues in blended families, the partners must consider and answer a variety of questions:
   • Should the surviving spouse get access to both spouses’ assets at first death?
     • If yes, should that spouse’s access be restricted or unrestricted?
     • When and to whom should the ultimate distribution be made?
   • How should family considerations be matched with estate tax considerations?
   • Which of the children should be taken care of? When should the children receive an inheritance? How should distributions for the benefit of children ultimately be made?
6. Estate planning professionals have plenty of ideas for dealing with the possibility of family strife.  Creating a written estate plan and keeping it current is the best way to plan to avoid issues after death.You may have estate planning questions of your own.  I’d be glad to visit with you to help sort them out.As always, please feel free to call to discuss these or other financial security issues of concern.

Investments and Transactions That are Off-Limits

The Internal Revenue Code specifically disallows certain assets as IRA investments. These include life insurance contracts and most collectibles. Excepted from this rule are certain gold, silver, and platinum coins, and bullion physically held by IRA trustees. Also disallowed is pledging IRA assets as security for a loan. Pledging IRA assets causes the portion of the account pledged to be treated as a distribution from the account, subject to income taxes and possibly withdrawal penalties if the IRA owner is under age 59 1/2.

Prohibited Transactions

IRA owners must also watch out for so-called self-dealing rules, or prohibited transactions. In general, these rules prohibit using IRA assets for the benefit of ‘disqualified persons’, and prohibit loans between the IRA and disqualified persons. Disqualified persons is defined as IRA owners and beneficiaries, and includes certain family members and controlled entities. Should a prohibited transaction occur, excise taxes, income taxes and loss of the account’s status as an IRA might result, with accompanying income tax liabilities and potential withdrawal penalties. Careful consideration must be given to whether or not the IRA owner or other disqualified person will benefit from a potential investment in any way other than by the investment return to the IRA account.

Unrelated Business Taxable Income

Unrelated business taxable income (UBTI) arises in IRAs in one of two ways:

• An IRA may invest in an unincorporated active business as a sole owner or as a partner; or
• The IRA may hold investments that are debt-financed (for example, real estate with acquisition financing).

If the alternative investment were to produce income, the income may be subject to income taxes on UBTI in excess of a $1,000 exemption. Trust tax rates would apply, which tend to be higher than individual tax rates. Also, the account would need to have enough cash available to pay the taxes. However, rental income is specifically excluded from the UBTI provisions, as are gains from the sale or other disposition of the property as long as it is not inventory or other business property. However, the debt-financed rules above still apply to rental property.

Valuations, Distributions

There are many situations in which IRAs are required to report the value of their assets and/or use those values for important tax calculations. Annually, IRA asset values are reported on Form 5498.  When account owners attain age 59 ½, and/or after their deaths, required minimum distributions (RMDs) must be calculated. Also, when IRA assets are distributed, their fair market values are used to determine the taxable amount of the distributions. Performing these valuations may require additional expense and involve hiring valuation experts. This is much different than simply selling marketable securities or checking public price quotes when values are needed.

Similarly, making distributions of partial interests in alternative investments may be cumbersome and expensive. RMDs to the account owner and distributions to multiple beneficiaries after the account owner’s death will require valuations and careful planning, or potentially the sale of the asset, in order to facilitate the required distributions.

Administrative Difficulties

Certain proposed unconventional IRA investments may pose administrative hurdles or risks within the IRAs. One concern would be investments that might require expenditures that could exceed cash that can be readily raised within the IRAs. In that category falls real estate requiring expenditures for real estate taxes, insurance and maintenance, and partnerships that could make capital calls on partners. Keep in mind that any payments of such expenses by IRA owners would be treated as contributions to the IRA subject to the limits on annual IRA contributions. Also, borrowing within the IRA to make the expenditures would likely be a hassle and cause debt-financed UBTI.

Planning is Key

Although administering unconventional investments within an IRA can be tricky, with dire consequences for slip-ups, some investors may be ready to explore their IRA options. With investment values at historic lows, this may be the perfect time to do so. Please contact us if you would like to start this discussion. We can help you navigate the waters if you are considering bailing out your IRA.