Posts Tagged ‘income tax’

We Are Creeping Up On a Quarter Century Here

JANUARY 4, 2016 VOLUME 23 NUMBER 1

Note the “Volume” number above. Is it even possible that we’ve been doing this for 23 years?

In that time, a number of topics have been perennially popular. We see a lot of internet traffic, and get a lot of questions or comments, when we write about:

Of all those topics (we now have an archive of well over a thousand weekly newsletter articles), which is our favorite? That’s easy: the one you read, gain something from, and have a follow-up question about.

So what’s your question? We won’t try to give individualized legal advice, but maybe we can help you with a relevant legal principle, or perhaps we can elucidate some of your alternatives. We will often tell you that the right answer is “consult an attorney,” but maybe you can get to the attorney’s office as a better-informed client.

Oh, and Happy New Year.

Things to Consider When You’re Named as Successor Trustee

NOVEMBER 2, 2015 VOLUME 22 NUMBER 40

When a family member dies, you will need to address a number of items. One that might come up: handling the revocable living trust they created.

If you are named as successor trustee you will have a number of obligations you need to discharge. You might need help from a lawyer and/or an accountant; you should not hesitate to consult one or both to figure out how much help you do need. Many of the successor trustees who consult us can do just fine without continuing legal help, but the process is not always easy or obvious.

We can provide you with an introduction to the considerations involved in handling a trust after the death of the trust’s settlor. Before we start, though, these caveats/warnings are appropriate: we’re only writing about Arizona law, and your situation might be very different than the other facts we assume here. Any questions in your mind about what needs to be done? Ask a lawyer.

With that in mind, here are some of the issues to consider shortly after the death of someone who named you as successor trustee:

What law applies? It’s not always obvious. If your mother signed her trust in Arizona and lived and died in Arizona, and you live in Arizona as well, her trust will almost certainly be governed by Arizona law. But what if she lived in another state and you live in Arizona? Or if the reverse is true? Or the trust says that another state’s law will apply?

The general rule: the law of the state where the trustee lives usually applies. That’s you, not your now-deceased mother. If you are the trustee, start by talking with a lawyer in your own community, and ask her whether she is the right person to advise you (of, if not, if she can refer you to someone in the right state).

Notice to beneficiaries. The law of many states — including Arizona — requires specific written notice to the beneficiaries of a trust after you take over as trustee of an irrevocable trust. Did you manage the trust for a time before your father’s death? Ask your lawyer about the applicable state law. This is an area where state laws differ.

Arizona says that notice is due within sixty days of a trust becoming irrevocable (as, for instance, upon the death of the settlor):

Within sixty days after the date the trustee acquires knowledge of the creation of an irrevocable trust or the date the trustee acquires knowledge that a formerly revocable trust has become irrevocable, whether by the death of the settlor or otherwise, shall notify the qualified beneficiaries of the trust’s existence, of the identity of the settlor or settlors, of the trustee’s name, address and telephone number, of the right to request a copy of the relevant portions of the trust instrument and of the right to a trustee’s report as provided in subsection C.

That’s Arizona Revised Statutes section 14-10813(B)(3). Note that it refers to a list of items the notice must include. You can read that description at the same link, but it basically requires information about the settlor, the trustee, the trust and its assets.

Identifying the beneficiaries. Who is a “beneficiary.” Suppose your father’s trust says that if you, all your children, and all your cousins die in a common accident, everything goes to a charitable organization. Does that mean that all notices have to be sent to that charity, too? Not necessarily.

Arizona defines people and organizations who need notice (they are called “qualified beneficiaries”) to include everyone who is entitled to (or even can receive) income or principal right now, plus anyone who could receive trust money if one thing happened (like the death of a beneficiary). That’s a bit of a simplification, but it should help figure out who is entitled to notice. The details are in Arizona Revised Statutes section 14-10103(14). It’s a little hard to read and interpret — talk to your lawyer about it if you have any difficulty figuring out who is a “qualified beneficiary.”

Review the trust. Not just the parts identifying the beneficiaries, or the list of successor trustees. Read the entire trust. It might tell you to do more than the law requires. In some cases, it might tell you that you can do less than the minimum spelled out in the law — though sometimes those provisions are ineffective. Talk to your lawyer if you have any questions about minimum or maximum requirements.

Certificate of trust. When your mother signed her trust, she probably created a short (two- or three-page) document that listed the trust’s name, her status as trustee and the name of her successor trustee (among other things). You will probably want to prepare a similar document as successor trustee, and it might need to be filed with the County Recorder’s office in any county where the trust owns real estate. Arizona Revised Statutes section 14-11013 tells you what you might include in that certification, but it doesn’t provide a form. Having a hard time finding a good form? That’s because every case is so different — depending on how many and who the beneficiaries are, what kinds of assets the trust holds, the relationship of the successor trustee, and other things. Ask your lawyer for help.

Taxes. You knew that taxes would be an issue, right? Someone (and it’s probably you) will need to sign and file a final federal income tax return for the part-year they lived. The trust will be a separate taxpaying entity, and will need to secure a taxpayer ID number (an EIN) and file at least one federal income tax return. There will need to be state income tax returns for the state where your family member lived, and for the trust in one or more states. This is a good item to discuss with your accountant.

There’s more. This list is far from complete. It’s an attempt to give you some idea of what you’re facing, and to help you figure out whether you need to consult a lawyer. Not sure? That’s the best evidence that you need to get good legal counsel.

Why You Aren’t Really Limited to $14,000 in Gifts Each Year

APRIL 27, 2015 VOLUME 22 NUMBER 16

There is so much misinformation (and misunderstanding) around gift taxes, that we thought we would take a few moments and try to straighten out the confusion. Let’s start at the end: if you live in Arizona, and are not fabulously wealthy, you probably don’t actually care very much about gift taxes. Now let us explain why.

Arizona doesn’t assess any gift tax, estate tax or inheritance tax, so those of us living in The Valentine State only have to understand federal estate and gift tax systems — unless, of course, we own property in one of the states that does impose a tax on such transfers. Meanwhile, a basic understanding of the federal gift tax is practically embedded in our DNA: you can make a gift of up to $14,000 per year, but anything over that is prohibited.

The problem with that basic understanding is that it is wrong. The magical $14,000 figure is just the number that Congress has set as being too small to even bother thinking about. Nonetheless, it has a strong hold on the public imagination — even though the number has only been set at $14,000 since 2013. The “don’t even think about it” number was $3,000 for four decades before rising to $10,000 in 1982; it started increasing in $1,000 increments in 2002 and will probably rise to $15,000 within the next couple of years.

In calculating whether you have made gifts of over $14,000, by the way, the federal government gives you three important additional benefits:

  1. The $14,000 figure applies to gifts to each person, not the total amount of gifts in a year. Do you have three children you want to make gifts to? No problem. You can give each of them $14,000 this year, for a total of $42,000, without having reached the threshold.
  2. Are you married? It’s simple to double the numbers — even if you (or your spouse) are actually making the full amount of the gift. A married couple can give away $28,000 without having to do anything more (though if all the money comes from one spouse there is one more step required — more about that later).
  3. Will the gifts be used for medical or educational expenses? The lid just got taken off. So long as you make your gifts by paying directly to the college, or hospital, or other provider, there is no $14,000 limit. You can pay your favorite granddaughter’s tuition and books directly, and still give her another $14,000 (double that if you’re married) without having to do another thing.

Does all that mean you are generally limited to giving $14,000 (each) to each recipient? No. That’s just the level below which you don’t have to do anything else but sign a nice card and make a notation in your check register. Want to make a $50,000 gift to your son, or your daughter, or your mailman’s nephew? No problem — you’re just going to have to file a gift tax return.

That sounds scary, but it’s really not. You won’t actually pay any gift tax unless the total amount you give away (over and above the $14,000 + tuition + medical expenses each year) exceeds $5.43 million dollars in your lifetime. And even that number is going up each year.

The bottom line: if you live in Arizona, don’t own property in a state that imposes a gift tax, and are worth less than about $5 million, you are simply going to be unable to pay a gift tax over your entire life, no matter how hard you try. That is also true, by the way, for estate taxes — you are going to have a very hard time incurring an estate tax in those facts, even if you want to do so.

So imagine that you want to make that $50,000 gift to one person (or two $50,000 gifts, or three) in 2015. How hard will it be to prepare and file the gift tax return? Not very. If you ask your tax preparer to do it for you, we predict that you will get charged a couple hundred dollars. You can almost certainly figure out how to file it yourself — just look for information about the federal Form 709. Things can get a little more complicated if you are giving away an interest in your business, or a fraction of a larger asset — you really will need to get professional help in such a case. But there’s no rule that says you simply can’t give away more than $14,000, or that you’ll pay any taxes or penalties if you go over that amount.

By the way, there’s a common misconception about other tax effects of gifts, too. There is no income tax deduction or adjustment for your gifts, and the recipient pays no gift tax on receipt of the gift. Of course, if you give away an income-producing asset the future income will be taxed to the new owner, but the only immediate tax effect of a gift in Arizona is the (almost nonexistent) federal gift tax.

Does all this mean we advocate making large gifts? Not necessarily. There are some secondary tax consequences of giving away larger assets — especially those that have appreciated in value while you owned them. Before making a gift of real property, or appreciated stocks, get good legal and tax advice. And there are plenty of non-tax reasons you might not want to give away a significant portion of your assets. But the federal gift tax shouldn’t be much of a disincentive for most people.

Income Taxation of Trusts — Not Just Special Needs Trusts

APRIL 6, 2015 VOLUME 22 NUMBER 13

We have previously explained the income taxation of self-settled special needs trusts and third-party special needs trusts. We focused on special needs trusts because, well, that’s what we do — and also because there seems to be so much confusion about special needs trusts. But that is not the only confusion out there. We find a lot of confusion about taxation of trusts, generally. Let’s see if we can clarify some of the issues.

The income tax issues are actually the same for trusts that are not “special needs” trusts. But the generalizations are a little harder to keep straight, since there is a much broader variety of trusts out in the world. So let’s see if we can lay out some questions and answers to help you understand the issues.

The first question: is the trust a “grantor” trust?

Why is this question the first (and probably the most important)? Because if the trust is a grantor trust it (a) does not need to have a separate taxpayer identification number (what is called an EIN, or Employer Identification Number, in tax language) and (b) should not file a separate tax return. If the trust is a grantor trust, you can (and usually should, if only for convenience purposes) use the grantor’s Social Security Number and report income on the grantor’s personal income tax return.

So how do you know if your trust is a grantor trust? Let’s ask a few qualifying questions:

  • Did you create the trust, or did the money in the trust once belong to you?
  • Is the trust revocable (by you)?
  • Are you the trustee?
  • Are you a beneficiary of the trust?

If you answer the first question “yes” and any one or more of the following questions “yes,” your trust is almost certainly a grantor trust. There are some exceptions, but they are relatively rare. Talk to your attorney and your tax preparer — and we recommend you talk with both. Why? There is a lot of misunderstanding out there, and neither lawyers nor accountants always get the answer right on this question.

What are the most common misunderstandings? You will sometimes hear accountants, bankers, stockbrokers and lawyers assure you that an irrevocable trust that names someone other than the grantor as trustee must have a separate EIN (and, presumably, file a separate tax return). That’s simply not true. It’s also not relevant to whether or not the trust is a grantor trust.

There are also some “magic” provisions in irrevocable trusts that are usually used precisely to make them grantor trusts. If, for instance, your irrevocable trust includes a provision that says the person who set it up retains the right to trade (“substitute”) property in the trust for their own property, it’s pretty likely that was included precisely to make sure the trust is a grantor trust.

What if the trust is not a grantor trust?

Then the trust will need an EIN, and it will file a separate income tax return. That does not necessarily mean it will pay any income tax, but it will need a return filed.

Depending on the language of the trust and the nature of its distributions, some or all (or, rarely, none) of its distributions will be taxed to the recipient — or to the person who benefited from the distribution. So, for instance, if a non-grantor trust sends cash to its beneficiary, the beneficiary will probably pay some income tax on the distribution. Same answer if, instead, the trust pays the beneficiary’s rent, college tuition and car payments directly — all of those distributions are for the benefit of the beneficiary.

Note that not all of the trust’s distributions will be treated as income to the beneficiary. Only the portion of the distributions that would have been taxed to the trust (that is, the trust’s income) will be subject to being passed through to the beneficiary. So, for instance, if a trust has $1,000 of interest income, and pays $15,000 in rent and tuition bills for the beneficiary, no more than that $1,000 figure will be taxable income to the beneficiary. At least some of the administrative costs will probably be deductible before calculating the tax effect.

How does the non-grantor trust report its income for tax purposes?

The federal tax form used by trusts is called the 1041 (it’s similar to, but different from, the individual’s 1040 income tax form). It actually looks a little simpler than the personal income tax return, but that’s misleading — some of the accounting and tax concepts are more complicated and less understood. We recommend that trustees get a professional to prepare the trust’s tax return.

What about state income tax returns?

The trustee will likely need to file state income tax returns that mirror the federal return. But for which state(s)? That’s a hard question to answer, and impossible to generalize about. Some states want trust income tax returns for any trust that has a trustee or co-trustee living in their state. Others look primarily to where any one beneficiary lives. Other states do not have income tax at all, and so do not require a trust to file an income tax return. Your professional tax preparer will want to consider at least: (a) the language of the trust, (b) the residence of all beneficiaries, and (c) the residence of all trustees.

Can any tax preparer handle a trust’s income tax return?

Yes. Probably. Maybe. Wait — let us ask you a question: have you asked the tax preparer how often he or she prepares trust income tax returns? If not, we suggest you might want to ask. The returns are not bewilderingly complicated, but they are unfamiliar to people — even professionals — who are not used to working with them. Your best bet: get a professional (probably a CPA, perhaps a lawyer or law firm) who does this kind of tax return on a regular basis.

Good luck getting through this tax season. We hope this helps. Be careful, though — there are exceptions and qualifications to the general rules we’ve outlined. Check with your experienced tax preparer or attorney before actually preparing returns. Better yet: let the professionals do it.

Income Taxation of the Third-Party Special Needs Trust

MARCH 23, 2015 VOLUME 22 NUMBER 12

Last week we wrote about how to handle income tax returns for self-settled special needs trusts. Our simple message: such trusts will always be “grantor trusts”, an income tax term that means they do not pay a separate tax or even file a separate return.

This week we’re going to try to explain third-party trust taxation. Unfortunately, the rules are not as straightforward or as simple. But that doesn’t mean you won’t understand them.

First, a quick definition of terms. A “third-party” special needs trust is one established by the person owning funds for the benefit of someone else — usually someone who is receiving public benefits. The usual purpose of such a trust is to allow the beneficiary to receive some assistance without forcing them to give up their Supplemental Security Income (SSI) or Medicaid (in Arizona, AHCCCS or ALTCS) benefits.

To figure out what to do about income taxes on the trust Jack set up, we need to consider a couple of questions:

  • Did Jack retain some levels of control over the trust while he’s still living?

If, for instance, Jack has the power to revoke the trust, or he stays as trustee, or even if he receives the trust’s assets back if Melanie dies before him, even this third-party trust may be a “grantor trust.” If it is, though, the grantor will be Jack — and he will probably pay any tax due on all of the trust’s taxable income. The trust will not need to have a separate EIN (tax number) and even if it does the actual income will usually be reported on Jack’s personal income tax return. None of the rest of this newsletter will be relevant to Jack’s income tax return.

What kinds of control might Jack have to trigger this treatment? There are volumes of suggestions and commentary written about that question, and it is impossible to answer without having spent some time reviewing the trust, its funding sources the IRS’s “grantor trust rules” and Jack’s intentions when he set it up. Some of the kinds of control might have been intentional, while others might surprise Jack (or even the lawyer who helped him draft the trust).

  • Does the trust treat principal and income differently?

Sometimes a trust might say that its income is available to the beneficiary, but not the principal (though this kind of arrangement is less common today than it was a few decades ago). In such a case the taxation of interest and dividends might be different from capital gains.

  • Does the trust require distribution of all income?

Some trusts mandate that the current beneficiary must be given all the trust’s income. That’s very rare in the case of special needs trusts (since the whole point is usually to prevent the beneficiary from having guaranteed income) but sometimes a trust might have been written before the beneficiary’s disability was known, and inappropriate provisions might still be included. If the trust does require distribution of income, it will be what the tax code calls a “simple” trust and will have some slight income tax benefit. But it also will probably need to be modified (if it can be) to eliminate the mandatory distribution language.

  • Has the trust made actual distributions for the benefit of the beneficiary?

It is a bit of an oversimplification, but usually trust distributions result in the beneficiary paying the tax due. That is true even though the distribution is not of income. Let us explain (but not before warning you that we are going to simplify the numbers and effect somewhat):

Assume for a moment that Jack’s trust for Melanie is not a grantor trust. It holds $250,000 of mutual fund investments, and last year the investments returned $20,000 of taxable income. During that year, the trustee paid $10,000 to Melanie’s school for activity fees (so that Melanie could participate in extracurricular activities, go on field trips, and have the services of a tutor). The trustee also received a $4,900 fee for the year.

Now it is time for the trust to file its federal income tax return (the Form 1041). The trust will report $20,000 of income, a $100 personal (trust) exemption, a $4,900 deduction for administrative expenses and a $10,000 deduction for distributions to Melanie. The trust will also send a form K-1 to Melanie showing the $10,000 distribution; she will be liable for the tax on the income. The trust’s taxable income: $5,000.

But what if the trustee also paid $15,000 for Melanie and her full-time attendant to spend a week at a famous theme park? As before, the trust will have a $5,000 deduction for the personal exemption plus administrative expenses, but distributions for Melanie’s benefit totaled $25,000 — and the remaining taxable income was only $15,000. The trust will report a $15,000 distribution of income to Melanie, and send her a K-1 with that figure. She will be liable for income taxes on the $15,000 and the trust will have no income tax liability at all.

We can come up with infinite variations on this story. Perhaps the trustee purchased a vehicle for Melanie, and had it titled in her name. Maybe there were payments for wages for that attendant. Each variation might change the precise nature of the deductions, reporting and taxation, but the bottom line will be (approximately) the same in each case. Distributions to Melanie or for her benefit will shift the taxation from the trust level to her individual return.

  • Is Melanie’s trust a “Qualified Disability Trust”?

Yes, it is. We slipped the controlling fact into our narrative quite a while back. Melanie receives SSI. The same would be true if she was receiving Social Security Disability Insurance (SSDI) payments. It could be true even if she was not receiving either benefit, but it probably would not be.

The effect of being a Qualified Disability Trust: instead of a $100 exemption (deduction) from trust income on the trust’s own tax return, the trust would get an exemption set at the current annual exemption amount for individuals. In 2015 that means the trust would get a $4,000 exemption — which could ultimately save the trust, or Melanie, the tax on that larger amount.

Some people resist understanding tax issues, thinking they are just too hard. We don’t agree. These concepts are manageable. We hope this helped.

Income Taxation of the Self-Settled Special Needs Trust

MARCH 16, 2015 VOLUME 22 NUMBER 11

This time of year, we are often asked about income tax issues — especially when a trust is involved. It may take us several newsletters, but let’s see if we can’t demystify the income taxation of trusts. We will start with the type of trust we most often get asked about: self-settled special needs trusts.

We will ask you to imagine that you are the trustee of a special needs trust, set up for the benefit of your sister Allie. This trust was funded with proceeds from a lawsuit settlement. Allie is on AHCCCS (she lives in Arizona, where we renamed Medicaid “the Arizona Health Care Cost Containment System” or AHCCCS), and she receives Supplemental Security Income (SSI) benefits.

[Note: everything we explain here would be the same if Allie was your son, or your aunt, or your husband. It would also be true if the money in the trust came from the probate estate of your grandmother, who left Allie a share of her estate in cash (as opposed to in trust). It would be the same if the court established the trust for Allie, or her mother signed the trust, or if you signed the trust as Allie’s guardian. This advice will probably also be correct if Allie is receiving Social Security Disability Insurance payments — on her own account or on your father’s account — and/or Medicare instead of Medicaid/AHCCCS. If the trust does not include a provision that the Medicaid agency must be paid back upon Allie’s death, the answers we give here might be incorrect — wait until next week to read about that kind of special needs trust.]

Allie never actually signed the trust, but because she was once entitled to receive the trust’s assets outright it is treated (for most purposes) as if she did establish the trust herself. Even though the trust was created or approved by the court, or signed by Allie’s parents, or established by her guardian, it is almost universally referred to as a “self-settled” special needs trust. Those few practitioners who don’t use that term almost all prefer “first-party” special needs trust (though there may be differences regarding whether to hyphenate either descriptive title). We’re going to refer to it as a self-settled special needs trust.

Allie’s self-settled special needs trust has another descriptive name: it is also a “grantor” trust. That term really only has meaning for U.S. federal income tax purposes, but that’s a pretty important purpose and so the term is pervasive. Is it possible that Allie’s trust is not a grantor trust? Yes, barely. The key shorthand way to double-check: look for a provision that says Allie’s Medicaid expenses must be repaid with trust assets upon her death. If that language is in there, either the trust is a grantor trust or someone has created a really peculiar instrument. If that language is not in there, there’s actually a chance the trust is not a grantor trust — before going further with this analysis, go ask a qualified attorney or CPA whether the trust is a grantor trust.

Let’s assume we’ve gotten past this issue, and we can all agree that Allie’s trust is a grantor trust. What does that mean for income tax purposes? Two important things:

  1. Allie’s trust will never pay a separate income tax (well, at least not as long as she’s alive). The trust’s income will always be taxable on her personal, individual, non-trust tax return.
  2. Allie’s trust will also never need to file a separate income tax return. In fact, it will never be allowed to file a separate income tax return.

There is a lot of confusion about Allie’s special needs trust. Does it need to get its own taxpayer identification number (actually, the correct term is Employer Identification Number, or EIN)? No. Then why do accountants, bankers, brokers, even lawyers keep telling you that it does? Because they are wrong, that’s why. Many of them believe that any time a trust has a trustee who is not also a beneficiary the trust must get an EIN. That is not correct.

But just because Allie’s trust doesn’t need an EIN doesn’t mean that it can’t have one. You are permitted to get an EIN for Allie’s trust if you want to.

Let’s assume for a moment that you have not gotten an EIN. In that case, every bank and stockbroker (anyone who pays money to the trust, in fact) should be given Allie’s Social Security number for reporting purposes. The trust’s income will simply be included on Allie’s 1040 (her personal income tax return). Some trust expenses may be legitimate deductions from income, but the Internal Revenue Service effectively ignores Allie’s special needs trust.

That was easy, wasn’t it? Let’s make it just a little more difficult.

Maybe you did get an EIN for Allie’s trust. What kind of tax filings should you make in that case?

Armed with an EIN, you should give that number to banks, stockbrokers and anyone else who holds the trust’s money. The trust’s EIN should not be on Allie’s own bank account (where her SSI gets deposited), even though you might be both trustee and representative payee — and the two funds should not be mixed.

As trustee, you will need to file a fiduciary income tax return — the IRS form number is 1041. It will be easy to file, however. You simply type on the form (there’s no box for this — just type it in the middle of the “Income” section of the form): “This trust is a Grantor Trust under IRC sections 671-679. A statement of items taxable to the grantor is attached.” The exact language is not critical, but that is the sense of what you should tell the IRS. Then attach a summary statement of all items of income and deductible expenses the trust has handled (things paid directly out of Allie’s Social Security account should not be included here).

That’s it. No tax payment. No deductions on the fiduciary income tax return. You are supposed to issue a 1099 (not a K-1, if you are in to those characterizations) for the dividend and interest income received under the trust’s EIN. Those things then get listed on Allie’s personal income tax return (her 1040), and taxed as if they had come directly to Allie — even though they didn’t.

That was pretty easy, wasn’t it? Next week we’ll look at third-party special needs trusts. If you want to get a little preview, you might consider the year-old but still excellent analysis from the Special Needs Alliance about special needs trust taxation.

New Tax-Related Numbers for 2015

JANUARY 12, 2015 VOLUME 22 NUMBER 2

Welcome to 2015! Who thought we’d ever make it?

The Internal Revenue Service did, that’s who. They’ve busily updated numbers for the upcoming year; most of the new numbers have actually been known for a couple months. Once you get used to writing “2015” every time, we have some other new numbers for you to memorize.

Estate tax threshold: The federal estate tax kick-in figure rises to $5.43 million for people who die in 2015. Somewhat confusingly, that is an increase from the $5.34 million figure applicable for deaths in 2014, so don’t assume that the new figure is just a transposition typo when you see it next. Of course, married couples now have a total of twice the new figure (or $10.86 million) to pass without federal estate tax — if they both die in 2015, that is.

Keep in mind that some states still impose an estate tax of their own. They might or might not increase the minimum figure with inflation (most don’t), so if you live in one of those states, or own property in one of those states, you also need to think about the state estate tax limit.

Also remember that the federal $5.43 million figure is reduced for taxable gifts you have made in past years. We’ll talk a little about gift taxes next.

Federal gift tax threshold: You don’t have to pay any federal gift tax until taxable gifts reach a lifetime total of $5.43 million — the same figure as the estate tax threshold. But gifts are even more favorably treated, since the first $14,000 you give to each recipient avoids taxation, filing or any other restriction. That $14,000 figure is the same as last year — it did not increase at all for 2015. Why not? Because, though it is indexed for inflation (and will rise in the next couple years) it only goes up in $1,000 increments. This year’s increase was not enough to cross the $1,000 notch.

You may already know that married people can pretty easily double the $14,000 gift figure. But you might not realize that it’s actually a little harder than most people think. If you and your spouse make a joint gift (if, say, the gift is from a joint account), you have nothing to file and no federal tax effect for the first $28,000 received by a given recipient. But if you write the check on your own separate account, you have to file a gift tax return (and your spouse has to sign it) in order to ignore the excess over your $14,000 gift. Confusing? Talk to your lawyer and accountant about the specifics.

This gives us a chance to mention a common misunderstanding, by the way. Again and again we hear clients say that they are limited to the $14,000 figure for gifts. That is incorrect. If our client says “oh, I knew that: I meant that I can’t give away more than $14,000 without paying a tax,” they are still wrong. It can be a little bit complicated to explain, but here’s how gift-giving works:

  1. If you give away more than $14,000 (twice that for a married couple) to a single recipient, you are required to file a gift tax return.
  2. When you do file your gift tax return, you only pay gift taxes on the amount by which your lifetime gifts exceed the $5.43 million figure (for 2015). In other words, if you have never owned more than $5.43 million in assets, you will have a very, very hard time incurring a federal gift tax, no matter what you do. You will also have a very, very hard time incurring a federal estate tax.
  3. If there is a tax on the gift, it is paid by the giver, not the recipient. Gifts are not deductible from your income tax, and they are not income to the recipient. The only federal tax associated with a gift is the federal gift tax, and it only kicks in after millions of dollars of total gifts.
  4. Married? Both the annual ($14,000) figure and the maximum lifetime gift ($5.43 million) figure are probably doubled.

Bottom line: only people who are both very wealthy and very generous need to worry about actually paying a gift tax. The real worry is about incurring the cost of filing a gift tax return — and that doesn’t kick in until that $14,000/$28,000 figure is reached.

Income tax rates: The basic chart of federal income tax rates is the same as in 2014, but with new figures for the bracket changes. In other words, in 2014 a married couple filing a joint return paid the lowest tax rate (10%) on the first $18,150 of taxable income. For 2015 that first-step threshold increases to $18,450 (a $300 increase). And the top bracket (39.6%) kicks in at a combined income of $464,850 this year, rather than the 2014 figure of $457,600.

Personal exemption and standard deduction: These two separate figures add up to an important principle for low-income taxpayers: if you don’t earn more than the combination of these two figures, you can’t be liable for any federal income tax. The personal exemption reduces your income before we even get to looking at your deductions. The standard deduction is the minimum amount that everyone gets to deduct from income before figuring out their tax liability, even if they don’t itemize deductions.

Both figures increase for 2015, but the increases are small. The personal exemption (you may get more than one, depending on marital status, age and other factors) will increase by a mere $50, to $4,000. For a married couple filing jointly, the standard deduction goes up by another $200. What does that mean for real taxpayers? If you are married filing jointly, and have just two exemptions available (and no dependent children), you don’t have to file at all unless your income exceeds $20,600 ($23,100 if you are both 65 or older).

One other “change” to mention: Last year a special tax opportunity expired. In 2013, if you had to take a minimum distribution from your IRA or 401(k), you could instead direct it to your favorite charity and avoid having to pay tax on it at all. Why was that valuable? Because even if you received the income and then gave it to charity, your charitable deduction wouldn’t cover every dollar of the gift. With this special authority, you really could avoid income tax on the distribution.

But wait! At the eleventh hour (actually, the twelfth hour) Congress brought back the 2013 deduction for 2014 — but not for 2015. So this change helps people who assumed that it would be extended, but doesn’t help anyone who tries to do the same thing in 2015. Unless, of course, Congress re-extends the authority later this year.

Even With No Estate Tax, Some Tax May Be Due on Inheritance

JUNE 9, 2014 VOLUME 21 NUMBER 21

Our clients are often confused about whether their heirs will owe any taxes on the inheritance they are set to receive. We don’t blame them — it’s confusing. Let us try to reduce the confusion.

The federal estate tax limit was raised to $5 million and indexed for inflation in 2011. That means that a decedent dying in 2014 can leave up to $5.34 million to heirs with no federal estate tax consequence at all. It is easy to double that amount for a married couple. And in 2006, Arizona eliminated its state estate tax — so there is no Arizona tax to worry about. That means that there is simply no tax concern for anyone not worth $5 million or more, right? The 99% can pass their entire wealth to their children without fear of tax consequences, right?

Of course that’s not right — it would be way too simple if that were the case. The world — at least the political world — seems to dislike simplicity as much as the physical world abhors a vacuum. Even if your estate is modest, you need to be aware of the tax consequences of leaving money to your heirs. Here are a few of the more common ways your estate might be subject to taxes on your death:

Living, and dying, somewhere other than in Arizona. About half the states, like Arizona, have no estate or inheritance tax. But that means that nearly half of the states do have a tax; some states tax the estate, and some the recipient of an inheritance. Before federal estate tax changes in 2006, it was possible to generalize about those state estate tax regimens — they tended to look alike. But no more. You need to worry about state estate taxes if you live in one of those states with a tax, if you own real estate in one of those states, or if you have heirs who live in one of those states. The details can be mind-bogglingly complex, and they are beyond our scope here. There are plenty of online resources to look up state-by-state rules — we tend to favor this 2013 article from Forbes magazine, partly because it is engagingly titled “Where Not To Die in 2013.” The information is already a year old as we write this, but not that much has changed, and it will give you a good head start.

Owning retirement accounts. You sort of knew this one already, right? You have an IRA, or a 401(k), or a 403(b) retirement plan, and you’ve named your children (or your spouse, or your helpful neighbor) as beneficiary. But keep this in mind: if you leave, say, $100,000 in an IRA to your children, they are going to receive something more like $70,000 of benefit. With careful planning, they can delay the tax liability — but they will pay ordinary income taxes on what they withdraw. Income tax will be paid by anyone receiving the retirement account (except a charity, of course — they pay no income tax), and at their ordinary tax rates. You might have arranged to minimize your own withdrawals, and pay a very low tax rate on the income you do take out — but your daughter the doctor and your son the architect might pay a much higher tax rate and have to start taking money out of the account immediately after your death.

What can you do about that issue? If you have charitable intentions, you can name a charity as beneficiary of your retirement account. You can leave it to grandchildren, who might pay a lower tax rate (and have more immediate use for the money). You can create a trust that forces your heirs to take the money out very slowly. But at the end of that process, some significant income tax is going to be paid by the recipient of your IRA or other retirement account.

Having income-producing property at your death. Arizona does not have an inheritance tax, so there is no tax cost to receiving an inheritance. Except that sometimes there is a small cost. If you leave an estate including, say, stocks and bonds, or mortgages secured by real estate, or anything else that receives income, your estate may incur a small amount of income tax liability during its administration. That can be true even if you create a revocable living trust, since it will typically take 6-12 months to settle even simple estates. But rather than your estate paying the income tax liability, it usually is passed out with distributions to your heirs. So when your daughter hears that there is no tax on her inheritance, she may be surprised when her accountant tells her she owes income tax on a few hundred — or thousands — of dollars of that inheritance.

Having property that has appreciated since you received it. Income tax is usually due on the gain in value of an asset during the time you held it. Most people realize, however, that when you die most or all of your property receives a “stepped-up” basis for calculation of capital gains. That means that your heirs usually do not pay any income tax on the increase in value during the time you owned property.

But be careful — that is not always true. If you gave the property away before your death, or you inherited it in a trust (like a spousal credit shelter trust), it might not get a stepped-up basis. That can mean that the property your heirs receive carries a significant built-in income tax liability. It might not be due immediately on your death, but it might limit their choices about when to sell or give away the property. This is much more of a problem today than it was just a few years ago — with the proliferation of A/B (credit shelter, or survivor/decedent’s) trust planning in the past three decades, a lot of property is now held in trusts and will not get a stepped-up basis on the surviving spouse’s death.

Owning an annuity. You might have done some clever tax planning by buying a tax-sheltered annuity five years ago. But if you die holding that annuity, your heirs might have to pay the income tax on the income accumulated during the years you have held the annuity, and they might have to pay it immediately. Note that tax-sheltered annuities are not called tax-free annuities — they are just a mechanism to delay the income tax liability to a later date when, one presumes, your tax rate might be lower. If your currently-employed children step into your shoes, that assumption might turn out to have been incorrect.

Planning options.  What can you do if you fit into any of these categories? If we are preparing your estate plan, we will talk with you about the issues. Any capable estate planning attorney should be able to see whether you have issues to be concerned about. But that is why we always ask you for detailed information about your assets, your family and your circumstances. Yes, the estate tax regimen has gotten simpler — but that doesn’t meant that the decision-making is necessarily simple.

Joint Tenancy with Right of Survivorship, or Community Property?

MARCH 24, 2014 VOLUME 21 NUMBER 12

Which is better? How should we take title to our house? How about our brokerage account?

These questions are really common in our practice. The answer is actually pretty straightforward, but we do need to lay a little groundwork.

Arizona is a community property state. That means that property held by a husband and/or wife is presumed to belong to them as a community. That presumption does not apply if the property existed before the marriage, or was received by a gift or inheritance. There are special rules for property you owned in a non-community property state before you moved here. It’s also possible for a married couple to enter into an agreement that changes the nature of community property, but those agreements are relatively rare.

Historically, there was one great disadvantage to community property ownership, and one great advantage. That is, there was one advantage and one disadvantage if you assume that the couple would never get divorced. If you have substantial separate property and are considering turning it into jointly-held property, is that advisable? That question is beyond our short essay today, and the answer depends on your comfort level with your spouse and marriage. We’re not particularly accomplished marital counselors, and we don’t have any facts for your personal situation.

But assuming you and your spouse live together more-or-less-happily until  one of you dies, here are the competing considerations to holding property as community property:

Advantage: Income taxes. Upon the death of one spouse, property held as community property takes on a new “basis” for calculating future capital gains. If you have stock that you bought at $1,000 and that you now sell for $10,000 (congratulations!), you have “recognized” $9,000 of gain and will pay income taxes based on that amount. But if you held that property in joint tenancy with your late spouse, it got a step-up in basis to his or her date-of-death value; assuming the stock was worth $10,000 on that day, your income tax is only on $4,500 of the total gain. But if you had held that stock as community property with your late spouse, there would be no capital gains tax on the sale at all.

Disadvantage: Probate. Until 1995, community property could not pass automatically to the surviving spouse. That meant that a probate was often required to transfer the deceased spouse’s community property interest to the surviving spouse. Since no probate was required for property held in joint tenancy (the “right of survivorship” part of joint tenancy means the surviving joint tenant receives the property without having to go through the probate process), most married couples opted for joint tenancy rather than community property.

In 1995, the Arizona legislature made the disadvantage to community property disappear — they created a concept of “community property with right of survivorship.” That means a married couple can have it all: they can get the full stepped-up basis for income tax purposes, but avoid probate, on the first spouse’s death.

Does that mean that all property should be titled as community property with right of survivorship? Almost, but not quite. There are a handful of problems that occasionally crop up and have to be considered:

  • Not every married couple intends to leave everything to one another. You can still get the full stepped-up income tax basis and leave your share of community property to someone else — your children from a prior marriage, perhaps, or another family member. In such a case it might make sense to hold the property as “community property” (with no right of survivorship) but have a will or trust to make provisions for each spouse’s share.
  • The income tax benefit does not always appear. Note that the benefit is not a direct tax savings, but only a potential savings. If you get a full stepped-up basis on property that you then hold until your own death, you haven’t really saved any tax money. But the community property benefit just might give you flexibility — you can decide to sell property after your spouse’s death on the basis of good investment advice, rather than the tax effect.
  • The option only applies (this is obvious, but we need to say it) to married couples. “Community property” is not available to anyone else. Is it available to same-sex married couples? We think so (see our articles on the subject over the last few months here, here and here), but we might turn out to be wrong about this.
  • The benefit may not even be necessary for some assets. No growth in your brokerage account? No benefit. You invest only in municipal bonds and certificates of deposit? Minimal to no benefit. But here’s the big one: most people’s biggest growth asset is their home — and there’s already a substantial ($250,000) exemption from capital gains taxes for a single (widowed) person selling their home.
  • Have you already established a trust as part of your estate plan? You may not need to go through the analysis, since the practical effect of your plan may be the same as the benefit of community property with right of survivorship — or better. Ask your estate planning attorney to review this with you.
  • There are sometimes costs to making the change. For real estate, you will need someone to prepare a deed (you can probably get it right on your own, but it makes sense to hire a professional). In addition, there are modest costs to record the new deed.
  • This only applies to Arizona property. No problem with your brokerage or bank account — they are Arizona property if you live here. Your vacation cottage in Montana, or your Mexican condo held in a land trust, are a different matter. But if your vacation cottage is in Alaska, or California, Idaho, Nevada or Wisconsin, you might be able to do something similar. Ask a local lawyer about the possibility.
  • We need to reiterate: if you have separate property and transfer it to community property with right of survivorship to take advantage of income tax benefits, you may have made a gift of half of your separate property to your spouse. Be careful, and make sure you know what you’re doing.

What’s your bottom line? Should you change everything you own from joint tenancy with right of survivorship to community property with right of survivorship? Maybe, but your home is the least urgent thing to tackle. Your brokerage account? Absolutely. Your summer cottage in another state? Check with your lawyer and ask her (or him) to find out whether the other state has community property with right of survivorship.

Note that none of this really helps you deal with retirement accounts, IRAs, 401(k) accounts, separate property you brought from another state or your complex estate planning intentions. For those, you really need to talk with your lawyer. Also, please be clear: we do not know the correct answer if you live in a state other than Arizona — talk to your local lawyer about that.

 

Tax Tips for Those Caring for a Child with Special Needs

MARCH 17, 2014 VOLUME 21 NUMBER 11

We last wrote about income tax issues associated with providing care and support for relatives two years ago — just before tax filing time. Since we’re just a month away from tax time 2014, it’s a good time to review and update.

What’s changed since our 2012 newsletter article on income tax issues? A couple things. But first, let’s take another look at the structure of the personal exemption and medical deductions.

You, as an individual taxpayer, get to claim a personal exemption of $3,900 for 2013 (the tax year you’ll be filing for next month). That means that, in addition to other deductions and tax rate calculations, the first $3,900 of income is tax-exempt. If you are married and filing as a couple, each spouse gets a single exemption.

You get another exemption for each person you can claim as a dependent. The easy ones: your minor children who live with you. In fact, you get to claim an exemption for your children until age 19 or (if they are in school) age 24. There are also rules governing when you claim an exemption for your minor (or student) children who do not live with you, but who depend on you for at least half of their support.

What if your child is over age 24 and still living with you? If they live with you at least half of the time, and you provide at least half of their support, you may still be able to claim an adult child as a dependent. In fact, that will be available for a parent, a sibling, a stepchild or foster child, or any descendant of any of those relatives.

There are actually two completely separate sets of rules about when you can claim a child or other relative as a dependent. The two categories are confusing because of their names: “qualifying child” and “qualifying relative.” A “child” for these purposes could be a parent or other relative (why would they make the terms easy to understand?), and a qualifying “relative” can be a child. So it’s hard to figure out exactly which category your child-or-other-relative fits into, but bear with us — there are some simple rules that will cover most of the situations.

Did your child (or other relative) live with you for at least half of 2013? Did you provide at least half of his or her support? If either of those questions can be answered “yes,” then you might well be able to claim them as a dependent and get that extra personal exemption on your tax return. Is your relative permanently and totally disabled? If so, then the exemption is probably available. The central question in most cases: did you provide at least half of your relative’s support?

A couple rules are still important to understand: your dependent can not also be someone else’s dependent — even their own. If they claim a personal exemption on their own tax return, you can not claim another one. You (and they) should figure out which exemption is more valuable as part of your analysis of whether you provide half of their support.

Note that for income tax purposes all sorts of relatives can be a “child.” Illogically, even your parents can qualify under the “qualifying child” exemption. While you’re reading about the tax terms, keep in mind that they might not make plain English-language sense.

In addition to the personal exemption, there are other tax benefits available to someone who is providing support and assistance for a family member with special needs or high medical costs. If you itemize your deductions, you can claim expenses for medical costs. Once again, be careful about assuming the tax code is using plain language — all sorts of things are possibly included as medical expenses.

For instance, if a doctor tells you that you should modify your home by, say, building a therapy pool or installing air conditioning, you might be able to deduct those costs. It may be necessary to figure out how much the improvements increase the value of your home and make appropriate adjustments — though that is not always required. Improvements to enhance accessibility, for instance, do not need to have an enhanced value calculation. This area is tricky: be sure you consult with your attorney or accountant before claiming a deduction for home improvement or modification.

Another medical deduction that is often overlooked: seminars and conventions where you learn more about care of your child with special needs. Do you go to the annual meeting of advocates for your child’s particular disability? If his or her doctor writes a letter indicating that you can learn better caretaking measures there, you may be able to deduct the cost of travel, registration and incidentals incurred at the seminar (but not food and hotel costs). Check with your tax preparer for details applicable to your particular situation.

Does your child benefit from acupuncture, chiropractic treatment or recognized religious healing? The costs may be deductible. Does your child have a guide dog or other assistance animal? Those costs are deductible — including procuring, training, veterinary bills, even food. How about legal bills for your child’s guardianship or other expenses? Sorry, probably not — unless they are necessary to authorize mental health care.

Back to our beginning question: what has changed since our 2012 article? Two important things, at least:

  1. The personal exemption, $3,700 in 2011 (that was the important figure in our 2012 article), is $3,900 for 2013. It will almost certainly go up again for 2014, which will mean a new number if we repeat this information next Spring.
  2. The deduction for medical expenses required your total deductions to be more than 7.5% of your income two years ago. That figure increased for current tax returns (for 2013): you now have to have deductions for more than 10% of your income in order to itemize at all.

What other income tax advice can we offer for taxpayers who take care of a child or other family member with special needs? There are a few things to look out for:

  • Supplemental Security Income (SSI) and VA Disability payments are not treated as income at all. That simplifies tax filing (and reduces taxes) for some special needs trust beneficiaries with income from their trusts that might otherwise be taxable.
  • You may be able to claim a credit for the cost of caretakers for your spouse or dependent if the expenses are necessary to allow you to work. Look at IRS form 2441 and ask your tax preparer for more details. Note that this is not a deduction subject to the 10% threshold — this is a tax credit.
  • If you do claim your child with special needs as a dependent in 2014 (that is, on the return you file next year), you will need to be sure to have him or her covered by health insurance — although Medicare or Medicaid will satisfy this requirement if he or she is on either program.
  • Is there a special needs trust in place? It will have specific tax consequences that you need to discuss with your tax preparer and/or your attorney.
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