Posts Tagged ‘IRS’

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 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.

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.

Same-Sex Married Couples Should Pay Attention to Income Taxes

MARCH 10, 2014 VOLUME 21 NUMBER 10

Income tax filing season is upon us, and so it’s an appropriate time to turn our attention to what’s new (or little-known) in the income tax world. We’re particularly interested, of course, in income tax issues that affect our clients, who usually are more interested in estate and gift taxes than income taxes. But there’s one subset of our clientele that really does need to focus on new income tax rules: same-sex married couples.

What’s new this year, of course, is that the U.S. Supreme Court has struck down a key part of the federal Defense of Marriage Act (DOMA). That federal law had said that even if a state chose to recognize same-sex marriages, the federal government would not accept that state recognition. After the Supreme Court ruling in United States v. Windsor on June 26, 2013, that principle was reversed. Later interpretations by the Internal Revenue Service (along with other agencies of the government) have expanded that reversal.

In the wake of the Windsor decision, the executive branch of the federal government has adopted a new approach to determining the validity and effect of same-sex marriages. The short version: if the marriage was recognized as valid where and when it was solemnized, it will be valid for federal (including income tax) purposes. That has been referred to as the “place of celebration” rule. It is sometimes called the “state of celebration” rule, but it is not limited to states — a marriage valid in a foreign country will work, too. Like, for one example, that of Edith Windsor and Thea Spyer, who were married in Ontario, Canada, in 2007, but lived in New York.

We still see a lot of confusion about the effect of the new IRS rules, though. Our gay and lesbian clients often believe that they are not married because Arizona does not (yet) recognize the validity of their marriage. Sometimes same-sex couples were married years ago and have since drifted apart — believing, perhaps, that they did not need to do anything to end a marriage that their home state stubbornly refuses to acknowledge. The new rules will require a rethinking of those relationships.

Here’s the bottom line for same-sex married couples: if you were legally married in another state or country, you need to file your federal income taxes this year (and for future years) as if you were married — because you are. That may mean that some couples actually pay more in total income tax — the well-known “marriage penalty” in the federal tax code will now apply to same-sex couples in the same way that it has long applied to opposite-sex couples. But it is not optional — a married couple, regardless of gender, can not decide to simply file as two single individuals regardless of what Arizona thinks of the validity of their marriage.

Does that mean that married couples who are no longer together need to file a joint income tax return? Yes — or they have to file as “married, filing separately.” Does that mean separated — but still married — couples have to communicate with each other, and share financial information? No, but if they file separately they are likely to pay more total tax, and it makes sense to talk through the options with a qualified income tax preparer.

Arizona also has a state income tax, of course, and it still refuses to recognize those same sex marriages. Since your state income tax filing starts with your federal tax return, a “married filing jointly” federal return is bound to confuse the state tax folks. So they have come up with their own form to make adjustments: it is called Arizona Schedule S and it is available on the Arizona Department of Revenue website. There are instructions for the Schedule S, and a version for 2012 taxes as well as 2013. (It could be worse: some states are requiring same-sex couples to prepare a federal return as if they were unmarried, just to attach it to their state tax return.)

Why is there a 2012 version of Arizona’s Schedule S? That leads to another point worth considering: if you were married before 2013, you may be eligible to (but you are not required to) amend your federal income tax return to file as a married couple. If you do, you will need to amend your Arizona tax return as well. You clearly have the right to amend your 2012 return, and you may be eligible to amend for 2011 as well — but note that if you amend for 2011 you will also need to amend for 2012 at the same time. Amendment rules are confusing, but the IRS has attempted to make them understandable on their generally excellent website.

There are other tax-related issues concerning same-sex marriages, and more opportunities for federal and state tax law to diverge.One we saw in our office this month: a surviving partner visited with us after the death of her long-time partner. She never mentioned that they had been married, thinking (as she later told us) that the marriage was not valid in Arizona. But when it came time to look at her partner’s Individual Retirement Account (IRA), it made a difference — even in Arizona. As a surviving spouse she had the ability to simply roll over her spouse’s IRA and continue to defer withdrawals until she reaches 70 1/2. If they had not been married she would have been required to begin withdrawals immediately, and faster. The lesson: don’t assume that Arizona’s failure to recognize your marriage means that it has no effect.

Most of the other changes, however, are considerably more arcane; the requirement that same-sex married couples file their federal returns as married (whether separately or jointly) is not arcane, and will have a big impact on those pioneers who got married in another state or country. Ask for advice, and share your marital status with your lawyer and your tax preparer.

Helping Care for Your Relative Provides Income Tax Benefits

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.

More on Types of Trusts — Some of the Less Common Varieties

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.

Trust Named as IRA Beneficiary? Here’s How it Works

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.

Estate Tax or Death Tax — Who Actually Pays Any?

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).

Want more? You can see the arguments in favor and against the estate tax, repeated endlessly, in any number of articles. Is the estate tax unfair double taxation, or an important tool to prevent outrageous asset accumulations?

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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).

Roth IRA Conversion in 2010 More Attractive For Some

JANUARY 11, 2010  VOLUME 17, NUMBER 2

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.

Do You Need a New Tax ID Number for Your Living Trust?

AUGUST 17, 2009  VOLUME 16, NUMBER 51

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:

  1. 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.
  2. 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.
  3. 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.

©2017 Fleming & Curti, PLC