APRIL 9, 2012 VOLUME 19 NUMBER 14
Federal and Arizona state income tax returns are due next week. It’s a good time to review tax deductions for one of the common situations we deal with: in-home (or, for that matter, institutional) caregiving for an infirm family member.
We wrote about an individual case involving long-term care deductions last fall. In that case no returns had been filed, so the taxpayer was playing catch-up — but the U.S. Tax Court agreed that she could deduct the expenses of in-home caregivers. The Court articulated a three-item test to determine whether the taxpayer was a “chronically ill” individual; once she had met any one test, the taxpayer could deduct her medical expenses, including the caregivers.
But what if the caretaking expenses had been paid by someone other than the taxpayer herself? If, for example, she had lived with her adult daughter and the daughter had paid for caretakers to come to the home?
In such a case the daughter should be able to deduct the expenses of care — provided that the patient is a “dependent.” That requires the taxpayer using the deduction to have provided more than half of the patient’s support, and is only available if the patient is a relative OR lived with the taxpayer.
The details about deducting medical expenses for a relative or someone who lives with you are spelled out in IRS Publication 502. Don’t fret about the official-sounding title — it’s actually straightforward and understandable. It also explains exactly what the IRS is looking for when you deduct your own OR a dependent’s medical expenses, and what documentation you will need to provide (or maintain in case you are challenged).
Of course the medical deductions only affect your federal income tax to the extent that they total more than 7.5% of your Adjusted Gross Income (AGI). For many people that limitation is hard to meet. Anyone paying for in-home caregivers, though, is likely to have gotten near to or exceeded the 7.5% threshold.
What about listing a relative (other than your minor children) as a dependent on your own tax returns? Is it possible that the daughter in our earlier scenario might be able to list her mother as a depedent if the mother lives in her home? For that matter, can she list her mother as a dependent if she lives in a nursing home or assisted living facility, but the daughter pays the bill?
The short answer in both cases is “yes.” A parent can be a dependent. That can mean, as described above, that their medical expenses may be listed as deductions on your return — but it also leads to a more direct benefit. If you can list your parent (or another relative) as a dependent, you can get an additional exemption — which reduces your taxable income even before looking for eligible deductions like medical expenses.
Can your parent be your dependent? Yes, but the requirements can be a little complicated. First, they must EITHER be a “qualifying relative” (pretty much any kind of relative you can name, including stepchildren and foster children) OR live with you. In addition, they may not have more than $3,700 (in 2011) of their own income. You must also provide at least half of their support. There are limited exceptions to some of those rules, but that’s the basic test for determining whether you can claim a parent or another person as a dependent. NOTE: these rules are not the same as the ones determining whether you can claim your minor children as dependents — THOSE rules can be much more detailed and complicated.
How can you figure out if you meet all the tests (and their exceptions)? You may not be surprised to learn that the IRS has a Publication to explain that. It is IRS Publication 501, and (just like the earlier Publication we mentioned) it is actually helpful and understandable information.
Can you get a direct credit for the caretaking services you provided for your mother yourself last year? Generally, no — and if you think about it that shouldn’t be too surprising. If you could deduct the value of those services, you would need to claim a similar amount as “income.” But that doesn’t mean that there is no tax benefit to having provided those services. First, they will help you establish that you have provided more than half the support necessary for your parent or family member. Second, you might be eligible to deduct expenses (but not the value of your caregiving) for a dependent. Look at IRS Form 2441 for Child and Dependent Care Expenses; the separate instructions for Form 2441 are (wait for it) straightforward and understandable.
Summing up: taking care of a relative (or someone who lives with you, even if they are not a relative) may be personally and emotionally rewarding. It will not usually be profitable. At least, though, there are some slight tax benefits for those who undertake what is usually a labor of love. Make sure you claim deductions and exemptions you are entitled to by virtue of your caregiving services.
JANUARY 24, 2011 VOLUME 18 NUMBER 3
Last week we wrote about different types of trusts you might have encountered, and tried to explain some of the generic terms, differences among and between types, and likely settings where a given type of trust might be appropriate. We wrote about spendthrift trusts, bypass trusts, special needs trusts and the difference between revocable and irrevocable trusts. Let’s see if we can clear up some of the confusion over less-common trust names.
Crummey trusts. In 1962 Californian Dr. Clifford Crummey created a trust for the benefit of his four children, who then ranged in age from 11 to 22. He was trying to address a problem with estate tax law: he could give the money to his children outright (and then worry about how they spent it) or put it in trust for them to protect it (but then not get it out of his own estate for estate tax purposes). His clever idea: put the money in a trust for each kid’s benefit, but give that child the right to withdraw his “gift” from the trust until the end of the year. When they didn’t exercise that right (hey — the youngest was only 11, and even the oldest would understand that withdrawing his money might affect future gifts) it would lapse, and the gift would be completed but stay in trust.
The Internal Revenue Service thought it was a trick, and they argued that Dr. Crummey and his wife had not made gifts at all. The IRS lost that argument, and the “Crummey” trust was born, in a 1968 decision by the U.S. Ninth Circuit Court of Appeals. If you’d like to read the actual decision in Crummey v. Commissioner you may — but we warn you that it will be interesting to only a few diehards, most of them lawyers or accountants.
For nearly a half-century, then, the Crummey trust has been a primary tool in the estate planner’s toolbox. The trusts have morphed over time — now they are often used to purchase life insurance (and may be called Irrevocable Life Insurance Trusts, or ILITs). The length of time for a beneficiary to withdraw the funds has been shortened in most cases — often to a month and sometimes even less. Some practitioners even give the withdrawal right to people other than the primary trust beneficiary. The Crummey trust in each case is an irrevocable trust intended to get a gift out of the donor’s estate for tax purposes but into a trust to control the use of the money after the gift is completed. With the present high gift tax exemption in federal law ($5 million for 2011 and 2012) the use of Crummey trusts will probably diminish appreciably.
Generation-Skipping trusts. In the simplest sense, a GST (practitioners love acronyms) is any trust that continues for more than one generation of beneficiaries. The “current” generation, if you will, might or might not have the right to receive income, or access to principal, of the trust — but it will continue until at least the death of that current generation representative.
GSTs are often constructed to skip multiple generations. The model for the maintenance of accumulated family wealth is usually the Rockefeller family — some of the trusts established by John D. Rockefeller before his 1937 death and valued collectively at over $1.4 billion at the time — are still chugging along for the benefit of his descendants.
Because of concerns about the accumulation of family wealth, and the avoidance of estate taxes in multiple generations by the use of such trusts, the federal government in 1976 introduced a new GST taxation scheme. More recent changes in the GST tax have driven the types, terms and use of GSTs. The GST tax is very high, but only applies (as of 2011 — the rules may change in two years or thereafter) to “skips” of over $5 million. Very elaborate GSTs are sometimes marketed as Dynasty trusts. One common problem in addition to tax issues: the common-law “Rule Against Perpetuities” may make it difficult to extend trusts for multiple generations. In Arizona it is now at least theoretically possible to extend a trust over more than 500 years without facing problems with the Rule. That is a sobering thought when you consider that 500 years ago the land that was to become Arizona was all but unknown to ancestors of the Europeans, Asians, Africans and even many Native Americans who live here now.
QTIP trusts. QTIP stands for “Qualified Terminable Interest Property.” Does that explain the trust type? Well, not quite.
In very general terms, a QTIP trust is probably designed for one narrow purpose. It permits a wealthy spouse to leave property for the benefit of a less-well-off surviving spouse without consuming the deceased spouse’s full estate tax exemption amount. In other words: if you were worth, say, $10 million dollars in 2009, when the estate tax exemption was at $3.5 million, you might have left $3.5 million to your adult children from your first marriage and most of the rest of your property in a QTIP trust for your second husband (or wife). That way your estate would pay no estate tax, and the tax would be due on the death of the surviving spouse. Since he (or she) had no property in our example, that means that his (or her) $3.5 million exemption would get used on your property first, and only the excess would be subject to taxation as it passed to your children from the first marriage.
As you can see, it is getting harder and harder to make a QTIP trust a good planning opportunity, except for extremely large estates with very high disparity in net worth between the spouses. But the QTIP trust isn’t dead yet — uncertainty about the federal estate tax, continued state estate taxes in some states (but not Arizona) and inertia preventing modification of older estate plans will all contribute to keeping the QTIP alive for a few more years, at least.
We don’t know about you, but we’re exhausted. Maybe we’ll tackle some more trust types on another day. Suggestions? Do you want to know about QDoTs (sometimes called QDTs or QDOTs)? QDisTs (Qualified Disability Trusts)? Cristofani Trusts? Just ask, and we’ll take a run at them.
OCTOBER 18, 2010 VOLUME 17 NUMBER 32
Three weeks ago we wrote about how to leave an IRA (or other qualified retirement plan) to a special needs trust for your child who has a disability. Two weeks ago we wrote about whether you should (and how you would) name any trust as beneficiary of an IRA. At the risk of getting too technical for most readers, this week we are going to tread lightly where few have gone before: let us explain what happens after you have named a trust as beneficiary of your IRA, and what choices the trustee of your trust might face.
First we have to clarify a couple of often-misunderstood concepts. We will write here about IRAs, but the same rules will apply to pretty much any “qualified” retirement plan. That means 401(k), 403(b), Keogh, SIMPLE, SEP-IRA and other plans will follow the same rules. Different tax rules apply to Roth accounts, but some of the same distribution principles will apply. For convenience, though, we will keep talking about IRAs.
There are actually several stages of IRA we might discuss. Let’s distinguish among them:
A regular IRA is “owned” by the contributor. There may be some community property rules in the state in which the contributor resides, or some marital rights attaching to the IRA in non-community property states, but for tax purposes the contributor “owns” the IRA.
One choice your beneficiary may have after your death is to “roll over” your IRA. If your beneficiary is your spouse, he or she can roll the IRA over into a new IRA in their name. This, incidentally, is where the IRA/401(k) (and etc.) distinction gets muddy; your spouse can roll your 401(k) account over into a new IRA. Those IRAs, whatever their source, are usually referred to as “roll-over” IRAs.
Spouses are not the only ones who can roll IRAs into a new account. Non-spouse beneficiaries can also do something similar, and the resulting accounts are often called “roll-over” IRAs, too. But they are different. They are also “inherited” IRAs (see below), and the beneficiary must begin withdrawing money from an inherited IRA immediately.
If a non-spouse beneficiary leaves your IRA right where it is, they become the owner but the IRA is now an “inherited” IRA. They can designate a beneficiary in case they die before withdrawing all the IRA funds, but any beneficiary will have to make withdrawals at your beneficiary’s rate. So, in other words, you name your 45-year-old daughter as beneficiary, you die, she names her 22-year-old son as her beneficiary, and upon her death he has to withdraw based on her actuarial life expectancy, not his own. She might have decided to move your IRA to another custodian; in that case she has an IRA that is both a “roll-over” and an “inherited” IRA.
With that background, the Internal Revenue Service has recently clarified how this all can work if you name a trust as beneficiary of your IRA. In Private Letter Ruling 201038019, issued on September 24, 2010, the IRA gave guidance to an individual taxpayer who requested approval for a proposed way of handling just this problem.
Private Letter Rulings, by way of background, are not intended to be official regulations or rules. They are individual guidance offered (for a substantial fee) to individual taxpayers who want to be sure they are not going to get in trouble. Although “private” in the sense that they apply only to that taxpayer, they are public in the sense that the IRS discloses them to everyone, and they do give some indication of how the IRS thinks about the issues addressed. You are probably safe proceeding on the basis of an Private Letter Ruling.
Here’s what the taxpayer proposed to do, and what the IRS approved, in the recent Private Letter Ruling:
The decedent had named his revocable living trust as beneficiary of two IRAs. He had three children, each of whom was to receive an equal share of the trust after his death.
The trustees of his trust proposed to divide each of the IRAs into three separate IRAs. In other words, there would be a total of six IRAs, still (for the moment) in the name of the decedent. Then each child would be named as beneficiary of two of the IRAs — one from each of the original IRAs.
Once that was accomplished, each of the six “transitional” (their term) IRAs would be rolled over into a new IRA. Each of those new IRAs would name one of the children as the inherited owner, and each child could then name his or her own IRA beneficiaries.
The custodians of those “final” six IRAs were each given a copy of the decedent’s revocable living trust, which was valid under state law and became irrevocable upon the decedent’s death. Those elements of the plan critical because they are required by federal tax law.
Each of the three children would be required to begin withdrawing their IRAs immediately, and at the rate calculated for the oldest of the three children.
The taxpayer’s proposed approach was fine with the IRS, but it would not necessarily be the only way to proceed. The trustee of the trust might be permitted, for instance, to leave the IRAs right where they were, to withdraw the funds over the period of the oldest child’s life expectancy, and to distribute those withdrawn amounts to the three children. But the IRS guidance makes it clear that this approach works, too.
The Private Letter Ruling doesn’t address one question. Why would the original IRA owner have named his trust as beneficiary if the IRAs were going to be distributed outright to the three children anyway? In such a case, we usually recommend that the owner name his children as beneficiaries directly — thereby avoiding the shortened payout period based on the oldest child’s life expectancy, as well as the need to go through the intermediate steps described in the Private Letter Ruling.
There are a number of reasons the IRA owner might have chosen to leave his IRAs to his trust. Usually those reasons include a disabled spouse, a child receiving public benefits, an unequal distribution of proceeds or some other complication. The Private Letter Ruling in this case does not give us enough information to determine which, if any, of those conditions applied. Still, it does give us valuable guidance for those cases in which a trust is named as beneficiary of an IRA.
AUGUST 9, 2010 VOLUME 17 NUMBER 25
Want to read about the debate over estate tax reform/repeal/reinstatement? There is plenty of literature. You can easily learn about the history of the estate tax (going back to 1797 in the United States, or to the 7th century BCE elsewhere).
How about real-life stories? You already knew that George Steinbrenner saved his family $600 million by managing to die during 2010 (although it turns out that the actual savings is much murkier and, probably, not near that number). But you probably have not heard of Iowan Eugene Sukup, who at 81 is contemplating what will happen to his considerable estate — and the family business — when he dies.
Maybe you make your decisions on the basis of the positions of famous people. How about what Bill Gates, Sr. (not the software innovator, but his father, who has spoken and written extensively on this subject) says about the estate tax? How about Alan Greenspan, former Federal Reserve chairman? Turns out it’s easier to find wealthy people speaking out in favor of the estate tax (albeit a “reasonable” estate tax) than against the tax altogether, but perhaps that is just because it is such a surprise, at least at first blush.
You know what is missing from most of the debate — and reporting — on the estate tax? Real numbers. Except for that last reference (the Washington Post’s “PostPartisan” blog), there is almost no mention in any of the articles collected here about how many people actually pay — or would pay — an estate tax on death. Are you curious? You may be surprised by the answer.
The best reference we could find is a December 18, 2009, report from the Congressional Budget Office. The non-partisan CBO manages, in a dense but readable 12-page report, to explain the interrelationship of the estate tax with gift taxation and the generation-skipping tax, provide a history of the revenue generated through the estate tax (shown as a percentage of all federal receipts), and describe the effect of all of the major proposals being considered by Congress.
It turns out that in 2004, when the estate tax applied only to estates worth more than $1.5 million, there were 19,294 estate tax returns on which the decedent’s estate owed any money to the federal government. That amounts to .82% of all deaths in 2004. Compare that to 1.14% of deaths in 2003 and 1.17% in 2002; in both of those years the estate tax applied to estates worth more than $1 million. Those details, incidentally, come from the Internal Revenue Service’s Spring, 2009 Statistics of Income Bulletin (if you try to locate the figures yourself, you’ll want to scroll down to page 222 of that lengthy report). The IRS has updated the figures for 2005 and 2006 and, not surprisingly, the percentage of taxable estates has dropped further. In 2005 (with a taxable level of $1.5 million, the same as in 2004), the percentage of taxable estates was .95. In 2006, when the taxable estate level went to $2 million, the number of estates reaching that level dropped to .63%. That was the smallest percentage since at least 1934, when the current tax code was first adopted.
So what does this all mean? Basically, with an estate tax level at about $1 – 1.5 million, right around 1% of decedents will pay any tax at all. At the $2 million level, that percentage drops to about 2/3 of 1%. If Congress proves to be paralyzed, by partisanship or otherwise, and the estate tax drops back to the $1 million level in 2011, then about 1% of decedents’ estates will, presumably, have to pay estate taxes.
That is not the end of the story, of course. It is not, for instance, the same thing as saying that 1% of people are worth a million dollars, or slightly more. Why are they not the same thing? For a variety of reasons, including:
Decedents are, of course, older than the general population. It is likely that the decedents in a given year are somewhat wealthier than the population as a whole, but the statistics we have described here do not show that or even hint at how much difference we should expect. One thing the statistics DO take into account: the IRS removed deaths of children from the figures, so the percentage of ALL deaths paying estate taxes would be slightly smaller.
Decedents with estates of just over the taxable limit have a variety of estate planning options to avoid any estate taxes. Married couples can plan to preserve the exemption for each spouse, those with slightly larger estates can use lifetime gifting, and devices like family limited partnerships and limited liability companies can reduce the value of the estate for tax purposes. Money left to charities or surviving spouses escapes taxation altogether. It is likely that a significant percentage of decedents transferred an amount of property to heirs that would have been taxable but for such techniques.
Even if 99% of decedents avoid estate taxes completely, that does not mean that the estate tax system had no effect on any of them. Presumably another small but significant percentage (perhaps 1-5%) expended at least some funds on the estate planning necessary to avoid estate taxation. We know of no study indicating how many have done so, or at what cost.
Inflation (if there is any) and wealth concentration trends will have continued since the 2002/2003 figures were calculated. In those years the percentage of decedents’ estates paying any estate tax were 1.17 and 1.14, respectively; of course, with the significant reductions in net worth for many Americans since those years the figures might actually drop for 2011. Over time, however, the percentage should be expected to grow. As it did, for instance, between 1987 and 1999, when the estate tax level remained constant at $600,000. During those twelve years, the percentage of estates subject to any tax increased from .88% (in 1987) to 2.3% (in 1999).
Of course, the estate tax level increased to $3.5 million in 2009 (before being eliminated entirely in 2010). The result of that near-doubling of the taxable level in one year has not yet been calculated and published. It will be interesting to see.
One final thought about the statistics developed by the IRS and the CBO: in 2004, with a taxable level higher than ever before and with the smallest percentage of decedent’s estates paying any tax whatsoever in the history of the modern estate tax, the IRS brought in a total of $22.2 billion. That was the fourth-highest haul in the history of the tax, and was about $4.5 higher than the two previous years, with taxable levels at $1 million (rather than the $1.5 million of 2004).
Recent changes in federal regulations affecting the Roth IRA now make this retirement savings plan available to wealthier individuals. We list some of the factors to consider in determining whether to convert your existing traditional IRA to a Roth IRA – so that you can discuss the matter in greater detail with your financial advisor.
What are the benefits of a traditional IRA? A traditional IRA allows you to contribute pre-tax dollars to your account. You pay taxes (on the original contribution, plus any increase in value) when you take distributions from the retirement account. The idea is, you will presumably be in a lower tax bracket when you are retired, and taking distributions, than you are as an employed person paying in to the account. The downside to the traditional IRA is that after you reach age 70½, you must take a minimum distribution from the IRA each year. The amount of the distribution is calculated annually and is based on the value of your retirement account and your life expectancy. If you are taking mandatory distributions each year, that will reduce the amount remaining in the account to pass along to your heirs when you die.
(It has long been the case that your spouse can inherit your IRA and continue to take annual distributions based on his or her own life expectancy. Other family members often had to cash out the account in five years, or fewer. Rule changes enacted in 2006 made it easier to pass along the remaining money in your IRA to people other than your spouse – a non-marital partner, or your kids, for example – and allow the beneficiary to take distributions over a longer period of time. See Elder Law Issues November 13, 2006 edition for more detail about those changes).
Why would I want to create a Roth IRA, when I already have a traditional IRA? A Roth IRA is funded with after-tax dollars. This means that as the account increases in value over the years, it increases tax-free. Unlike the traditional IRA, there are no mandatory distribution requirements for the account owner – meaning that more money remains in the account to pass along to your heirs. Although distributions will be mandatory for your heirs, the distributions are tax-free. If you have other sources of income, and you plan to use your retirement account mostly as a vehicle of passing money along to your heirs, rather than to fund your own retirement, a Roth IRA may be preferable to a traditional IRA.
Why are you telling me about a Roth IRA now? Until now, the Roth IRA has only been available to taxpayers whose annual income is less than $100,000. Effective January 1st, taxpayers whose income exceeds $100,000 can convert their traditional IRAs to Roth IRAs. This means having to pay the tax on the account contemporaneously with the conversion. And if you make the conversion in 2010, you can spread out the tax payments over two years.
Why might converting from a traditional IRA to a Roth IRA be a good option?
If you believe that the income tax rate will only increase in the future, you might decide that it makes sense to pay the tax now, rather than pay it at a higher rate twenty or thirty years down the road.
If you have sufficient wealth that you don’t think you will drop into a lower tax bracket upon retirement – or if you plan to leave your retirement account to your kids and they will be in a higher tax bracket – it might make sense to pay the tax now.
If your traditional IRA has suffered a big decline in value over the last couple of years (and whose hasn’t?), you may find it more appealing to convert it to a Roth IRA and pay the tax now, in the hope that the account will increase in value (tax-free) over the coming decades.
You are making a bet, though, that Congress won’t decide to begin taxing the capital gains on the Roth IRA. And, you will need to have money available in order to pay the tax on the conversion – preferably, money coming from a source other than your traditional IRA.
What factors should I consider in making the decision? Here are a few:
The availability of funds to pay the taxes now;
Your willingness to pay taxes now, rather than later;
Whether you are already taking distributions from your IRA;
When you plan to retire; and
Whether you intend to live off your retirement account or pass it to heirs.
There are rules about making the conversion (or, having made the conversion, undoing it) and the timing of paying the taxes for the conversion (a lump sum versus installments over two years). There are penalties for withdrawing funds from a Roth IRA within the first five years of establishing an account. For all of these reasons, we encourage you to have a candid conversation with your financial advisor, to see if converting your traditional IRA to a Roth IRA is right for you.
Imagine that you are trying to change the title on your bank account into the name of the living trust you and your spouse just set up. The nice lady at the bank is telling you that you need to get a new tax identification number for the trust. Could she be right? In a word, no.
Because we are lawyers, however, it is very hard for us to answer a complex question with a single word. So let us review some of the variations with you.
Is your trust revocable? This is the easiest variation. Give the bank (and your credit union, and your broker) your Social Security number. Joint trust between you and your spouse? No problem. Give them either Social Security number — just like before, when both of your names were on the account as individuals.
What if the trust is irrevocable? This is a little more confusing, but ultimately the answer is probably the same. If you receive any significant benefit from the trust, and your money went into it in the first place, you still use your Social Security number.
Is someone else the trustee of your trust? The answer is still the same — though many bank and brokerage officers will insist that this is what makes it mandatory for you to get a separate tax number. Simply put, they are wrong. If the trust is revocable use your Social Security number regardless of who the trustee might be. If it is irrevocable and someone else is the trustee, but you still receive benefits from the trust, use your Social Security number.
What if the trust is a “special needs” trust set up with your personal injury settlement or other funds? You still use your Social Security number. The “special needs” designation does not change the answer.
What about the “special needs” trust you set up with your money but for the benefit of your child? Now we’re getting interesting. Can you revoke the trust? What happens if your child dies before you do — does the money return to you? In either case, you probably use your Social Security number, and report the income on your tax return. Talk to your accountant and/or lawyer — don’t accept the banker’s (or broker’s) analysis of the legal and tax implications.
Is there ever a time when a new tax ID number is required for a trust? Yes, though the circumstances requiring a separate number are not as numerous as most bank officers, brokers and (for that matter) accountants think. These are not the only situations requiring a new number, but the three most common are:
Life insurance trusts, or so-called “Crummey” trusts. Just because your trust owns life insurance it does not automatically follow that this special rule applies, but if it was set up precisely to own life insurance, and you are not the trustee, it likely needs its own number.
A trust that becames irrevocable because of the death of the person setting the the trust up in the first place. This can happen when one spoue dies and a trust becomes partly irrevocable, too.
A special needs trusts you set up (with your money) for the benefit of someone else, but which does not revert to you if the beneficiary dies before you — especially if you are not even the trustee.
When a separate number is required, what kind of number is it? The actual name for a tax identification number for a trust is “Employer Identification Number” or EIN. That is true even though the trust may not have any employees. The common acronym “TIN” (tax identification number) is not really an IRS or Social Security term at all — it is usually used as an umbrella term to encompass both EINs and Social Security numbers.
Why do bankers and stockbrokers insist that I need a new tax ID number if I do not? We’re puzzled, too. Our best answer: they are reading from a prepared list of choices, and they do not really understand the reasoning behind the various categories and approaches. We have had good experience talking with the bank employee on behalf of our clients, but sometimes it requires working up through the levels of authority.
Did you already get an EIN (Employer Identification Number) for your trust? Is that a problem? Probably not. You have two choices: change the tax identification number on all the accounts back to your Social Security number and file a final income tax return for the trust, or file annual tax returns under the trust’s EIN but without including any income or expenses — list those on your own tax return instead.
There is a lot of confusion in the financial industry about tax identification numbers and trusts. Feel free to print this out and take it to your banker.
Income tax protestors may really believe that they can choose to opt out of the federal government’s income tax system. Some objectors may think they are making an important political point. They keep losing, however, and paying extra taxes and court costs for making arguments that are simply specious.
A case in point: Californian Andy Hromiko. Mr. Hromiko is a computer analyst and programmer, and worked for Duraflame, Inc. and California Cedar Products, Inc. He also was the trustee of MatrixInfoSys Trust, which he apparently set up for the purpose of avoiding payment of income taxes.
When Mr. Hromiko failed to file tax returns from 1994 to 1997 the Internal Revenue Service determined his tax liability for him and sent a bill for about $80,000 in taxes and another $25,000 in penalties and interest. Mr. Hromiko objected, arguing that he had received no income. MatrixInfoSys Trust, he said, had been paid for his services, and so he was not liable for taxes.
The IRS responded in kind. It first determined that MatrixInfoSys Trust was liable for slightly more in taxes and higher penalties, and then brought an enforcement action against both Mr. Hromiko and the trust. One or the other, reasoned the IRS, owed taxes on Mr. Hromiko’s earnings.
Mr. Hromiko responded as organized tax protestors usually do. He argued that the IRS was precluded from suing him because of the doctrine of “unclean hands,” that the tax system itself is illegal, that the government had committed fraud and duress, and a host of other quasi-legal arguments. Mr. Hromiko even went so far as to file a “revocation” of any agreement he might have made with the United States government regarding the Social Security system.
As in every other case involving similar tactics and issues, the court in Mr. Hromiko’s case shot down his arguments summarily. The court found that he earned a wage, and that he owed the tax. Having his wages paid to a trust did not change the fact that he earned the money and the tax was due. There is no clever, magical way to declare oneself independent of the federal tax system.
Mr. Hromiko was ordered to pay the entire tax due plus interest and penalties. In addition the Tax Court decided that his conduct should be separately sanctioned. Mr. Hromiko “has wasted the time and resources of this Court,” wrote the Judge, and he was assessed an additional $12,500 court penalty. MatrixInfoSys Trust v. Commissioner, June 7, 2001.
Bottom line: sham trusts, “constitutional trusts” and similar “tax avoidance” devices do not work. Before considering a trust for tax avoidance purposes seek out a competent legal adviser. Expect him or her to tell you to save your money for the tax man.
Discussions about repeal of the federal estate tax often focus on the notion that farms and businesses are threatened by taxing assets at the death of the family patriarch or matriarch. Opponents of repeal, on the other hand, argue that it is family and business dynamics that usually causes sale of farms and businesses. Katherine Pillot Lee Barnhart’s estate lends support to both arguments.
When Ms. Barnhart died in 1975 her estate was worth $12 million. Almost all of that value was tied up in two family ranches and several pieces of undeveloped land in Houston.
Ms. Barnhart had named her son Ronald E. Lee as executor of her estate and as trustee of two trusts she established for the benefit of her children and grandchildren. Mr. Lee began to administer the estate and the trusts shortly after his mother’s death, although there were few assets to permit payment of estate debts.
The first debt facing Mr. Lee was the federal and state estate tax liability. The IRS wanted $2.8 million in taxes, plus another $475,000 in interest by the time the tax liability was finalized. The State of Texas wanted $800,000.
Unfortunately there was no cash available to pay the tax bill. When Mr. Lee received an unsolicited offer on a 61-acre parcel of land in Houston, he sold it for a total of $19.5 million. After paying the tax bill he made the first distribution to his sister. Five years after her mother’s death, Susan Lee received $15,784 from her mother’s $12 million estate.
In all it took 13 years and two separate demands before Susan Lee decided her brother was not going to provide an accounting for his administration of the estate. She sued to remove him as trustee in late 1988.
She learned that Mr. Lee had charged fees totaling $2,836,000 to manage the trust property. He had failed to list any of the real estate for sale, and had refused several unsolicited offers as inadequate. He had spent over $700,000 in a failed effort to develop one of the parcels. He had continued to operate the family ranches at a loss rather than arrange their sale.
A jury decided Mr. Lee should be removed as trustee and reimburse the trusts $2.2 million in excessive fees, plus another $2 million in attorney’s fees, interest and other costs for the decade-long legal fight. Despite the jury’s award the trial judge reduced the judgment to less than $700,000 after finding that most of the excessive fees permitted substantial estate tax deductions, so that the estate was actually injured by a much smaller amount.
The Court of Appeals reinstated the jury award. It also added $300,000 for Susan Lee’s appellate costs, and ordered that the $1.5 million she had received for attorneys’ fees at trial should come from Mr. Lee’s own pocket. Lee v. Lee, February 8, 2001.
Was the estate tax liability of $4 million responsible for the break-up of Ms. Barnhart’s $12 million estate, or was it family infighting, greed and manipulation? Critics of the taxation of estates can point to the likelihood that Ms. Barnhart’s estate plan would likely have been more responsive to the family’s needs if estate taxes had not been an issue. Opponents of repeal can point to the fact that Ms. Barnhart’s estate was illiquid, and her chosen successor apparently unreliable, or at least unsuited to the task of managing the family’s considerable wealth.
Gay and lesbian couples need to take special steps to make sure that their wishes are carried out at death. The law makes some assumptions about the intentions of married couples—that they usually intend to leave their property to one another, for example. There are also tax rules benefiting married couples that are not available to same-sex couples.
Mary Scott and Lucille Horstmeier lived together in Illinois for nearly twenty years. Ms. Horstmeier was a locally prominent businesswoman, while Ms. Scott managed the household, handled the couples’ finances and took care of housework and repairs. For some of the time they lived together, Ms. Scott worked at the school Ms. Horstmeier managed, but her earnings were considerably lower than her partner’s.
In 1975 the two women moved into a new home in Glenview, Illinois. Ms. Horstmeier made the down payment and all subsequent payments, and took the title in her name alone. While Ms. Scott contributed some of her earnings to the household over the ensuing years, she never contributed directly to the mortgage payment on the home.
Ms. Scott maintained that the two women agreed that they would own the home jointly, and that her name was left off the title only because she did not have a down payment or a steady income at the time they bought their home.
One problem that frequently arises in similar situations can occur when the couple separates, or one partner dies, and no arrangement has been formalized for division or transfer of the property. Ms. Horstmeier, however, had planned for her own death—she made a will leaving all her estate to Ms. Scott and naming Ms. Scott as her executor.
When Ms. Horstmeier died in 1993, however, there was still a problem. Because she had been successful her estate was large enough to incur an estate tax liability. If Ms. Scott could have been treated as a surviving spouse there would have been no problem, since estate tax law permits an unlimited amount of money and property to pass to a spouse without tax. But Ms. Scott’s problems with the IRS were even larger.
Since she believed that she was already a one-half owner of the couple’s home, Ms. Scott reported only half the value of the home (minus half the remaining mortgage) on Ms. Horstmeier’s estate tax return. The IRS disagreed, insisting that the entire home had belonged to Ms. Horstmeier. The distinction was important, since the IRS position produced an additional $157,404 in taxes.
The IRS position prevailed in the Tax Court, and Ms. Scott appealed. The appellate court agreed with the Tax Court, and ordered the tax paid. Scott v. Commissioner, September 8, 2000.
What could Ms. Horstmeier and Ms. Scott have done differently? They could have taken the title in their joint names and made joint payments on the mortgage, or even signed a written agreement in advance. The planning they did complete was good—without it the home might have gone to Ms. Horstmeier’s relatives instead of Ms. Scott. They should also have anticipated yet another problem facing same-sex couples in their effort to achieve the benefits routinely available to married partners.
Lawyers’ clients often complain about the language of the law—it seems unnecessarily strained and convoluted. Even as lawyers try to capture their meaning in more conversational tones, an occasional case will demonstrate the importance of precise language. Kenneth Starkey, whose will was written by his lawyer son, is an illustration of that point.
Weeks before his death Mr. Starkey asked his son for help in drafting a new will. He wanted some of his estate to go to educational funds for his grandchildren, but he also wanted to leave a considerable portion of the estate to charity. This would not only permit his accumulated wealth to finance good works, but also would reduce the estate tax liability due upon his death.
Mr. Starkey particularly favored Lawndale Community Church in Chicago, Illinois, where Pastor Wayne Gordon was (and apparently still is) Director, and Milligan College in Tennessee, a small Christian liberal arts school. His will included a trust which would ultimately be valued at about $1.3 million, and which paid half of its income to Lawndale Community Church, so long as Pastor Gordon remained as Director. The remaining income of the trust, and the principal itself after Pastor Gordon’s retirement, was to be maintained “for the benefit of [Lawndale], missionaries preaching the Gospel of Christ, and Milligan College.”
While that language may look like a charitable bequest, the Internal Revenue Service disagreed. It read the trust’s terms as creating three intended beneficiaries: Lawndale Community Church, Milligan College and a group of unspecified missionaries. The estate argued in vain that “missionaries preaching the Gospel of Christ” was just a description of Lawndale Community Church’s well-known work in the missionary field.
The significance of this linguistic dispute was not minor. If the IRS interpretation was correct, Mr. Starkey’s estate owed an additional $520,178 in estate taxes. To help interpret the questioned phrase, the estate brought an action in Indiana’s probate court, had the court appoint an attorney to represent the unspecified “missionaries preaching the Gospel of Christ,” and secured an Indiana Court of Appeals ruling that the questioned phrase merely described Lawndale Community Church.
The IRS still insisted that the tax was owed, and so the estate paid the tax and appealed the IRS’ interpretation to the federal courts. The Indiana Federal District Court sided with the IRS and denied the estate’s request for a refund. The estate pressed on, and the Seventh Circuit Court of Appeals reversed that decision, ruling that Mr. Starkey’s charitable intent was clear and the tax was not owed. Estate of Starkey v. United States, August 17, 2000.
Ultimately Mr. Starkey’s charitable intent was vindicated in the courts, but not until four different courts (two Indiana State courts and two Federal courts) had considered the meaning of the disputed phrase. The cost of securing the favorable tax treatment is unreported, but was probably itself significant.
