Alaska Community Property Trusts

There is a planning strategy that could reduce income taxes for married couples.  The Alaska Community Property Trust permits married couples to transfer assets to a spouse at death, totally eliminating capital gains on all appreciated assets owned by the couple.

Married couples who live in the ten Community Property states (Alaska, Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington and Wisconsin) and hold their assets as community property receive a full "ste-up" in basis at the death of the first spouse for purposes of determining capital gains tax when the property is later sold.  Consequently, residents of community property states benefit from a significant capital gains tax savings by holding appreciated property as community property, an advantage unavailable to the rest of the nation, where only the assets of the deceased spouse would receive a step-up in basis (typically considered 1/2 of joint property).

Alaska, however, specifically allows non-Alaska residents who meet certain criteria to "borrow" the features of Alaska Community Property law and eliminate capital gains on their appreciated assets at the death of the first spouse.  It is now possible for you to transfer your appreciated property to a special trust drafted to take advantage of Alaska Community Property Trust features. 

Upon the first spousal death, the survivor of beneficiaries can then sell the property paying tax only on the gains above the date of death value.  If you read this, and are interested, please contact me.

Note: The rules for basis step up in 2010 are particular to 2010, this post does not address the 2010 issues.


Patrick

Business Exit Planning Using Charitable Strategies

Business owners usually have four goals when they leave their businesses: retire from the business; sell to a new owner (family members, employees, or third parties); minimize taxes and maximize profits. For those who are already charitably inclined, business exit planning using charitable tools allows them to add a fifth goal: doing good things for their favorite charity or their community.


Tools for Business Exit Planning Involving Charitable Giving

Three tools involving charities are typically used in business exit planning: charitable remainder trusts, gift annuities and charitable lead trusts.

A charitable remainder trust (CRT) is a tax-exempt trust. It is primarily an income tax planning tool with some estate and gift tax benefits. With a CRT, the appreciation in assets can be realized without immediate gain recognition tax-free, a stream of payments created for the donor and a deferred benefit provided to a charity. An income tax deduction, gift tax deduction or estate tax deduction is based on the remainder value that passes or is projected to pass to charity at the end of the trust term. Certain private foundation rules apply, which can be problematic.

A gift annuity is essentially a bargain sale in which the consideration paid by the charity is in the form of annuity payments. Code Section 72 specifies how the income is categorized; i.e., how much is return of principal and how much is ordinary income. Code Section 1011 specifies how gains are recognized, for example if the gift annuity is funded by contribution of appreciated assets. Code Section 415 limits payments to one or two persons. Private foundation rules do not apply to gift annuities.

A charitable lead trust (CLT) is the opposite of a charitable remainder trust in that the income stream is paid to charity with the remainder going to private individuals. A CLT is primarily an estate or gift tax tool. If it is set up as a grantor trust, it can also provide some income tax benefits. Unlike a CRT, a CLT is not a tax-exempt trust. Some private foundation rules apply to CLTs.

Business Succession Pitfalls

When trying to do charitable planning in conjunction with business exit planning, there are three potential pitfalls: having the transaction treated as a prearranged sale, the unrelated business taxable income (UBTI) rules, and the rule against self-dealing, which is one of the private foundation rules.

Prearranged Sales

Most business owners want a high degree of control, especially when it comes to selling their business. Often they will want to negotiate the sale, execute a binding sale contract, and then transfer the property subject to the sale obligation. That will not work because it violates the prearranged sale rule. Violating that rule means that the IRS will treat the donation as but one step in a unified transaction. Revenue Ruling 78-197 provides:

[The IRS] will treat proceeds of a redemption of stock...as income to the donor only if the donee (charity) is legally bound or compelled by the corporation to surrender the shares for redemption.

Under Rev. Rul. 78-197, the key then is whether the charity (or the Trustee of the CRT or CLT) is obligated to sell the donated property to the buyer that the donor has identified.

If the donor violates the prearranged sale rule, the sale proceeds will be income to the donor and the donor will not avoid recognizing the capital gains on the sale.

Planning Tip: The donor can identify and let potential buyers know that the business is for sale and even negotiate a sale price as long as the charity or Trustee is not obligated to go through with that sale.

Unrelated Business Taxable Income (UBTI)

All tax-exempt organizations and charitable trusts are subject to tax on UBTI. UBTI is income from a trade or business that is owned and regularly carried on by a charity or charitable trust that is not substantially related to the tax-exempt function of the charity.

Exceptions include dividends, interest, annuities, royalties, certain rents from real and personal property and capital gains - unless they are derived from debt-financed property.

Income from debt-financed property is UBTI regardless of whether the organization is actually engaged in a trade or business. Debt-financed property is any property held to produce income and with respect to which there is acquisition indebtedness. Acquisition indebtedness generally means indebtedness incurred when acquiring or improving the property.

A charity has acquisition indebtedness when it acquires property (by a gift or purchase) that is subject to debt or borrows against the property to make improvements. Property is considered "debt-financed" even when the charity or trust acquires the property "subject to" the debt.

There are, however, a couple of exceptions:

• An organization will not recognize UBTI solely because the property is debt-financed property for 10 years after receipt if the transfer occurs because of the donor's death.
• Lifetime gifts are not considered "debt financed" if three conditions are met: the organization does not assume the debt, the donor had owned the property for more than five years at the time of the contribution, and the debt had existed on the property for more than five years at the time of the contribution.

The Income Tax Impact of UBTI

A charity, including one with gift annuities, must pay tax on all of the UBTI it receives.

For CRTs, any UBTI is confiscated through a 100% excise tax. (The rule used to be different - that if a CRT received any UBTI in a year, all of its income for that year was treated as UBTI.)

For CLTs, when it makes a distribution of the unitrust or annuity amount to the charity, it takes a 100% deduction. However, if the CLT has UBTI, this deduction drops to 50% if paid to a public charity and to 0% if paid to a private foundation.

Self-Dealing

Code Section 4941 lists six specific acts of self-dealing for a private foundation:

1. The sale, exchange or leasing of property between a disqualified person and the foundation, regardless of the size of the transaction;
2. Loans of money or any other extension of credit between a disqualified person and the foundation;
3. The furnishings of goods, services or facilities between a disqualified person and the foundation;
4. The payment of compensation or reimbursement of expenses by the foundation to a disqualified person;
5. The transfer of income or an asset from the foundation to a disqualified person for the disqualified person's use or benefit; and
6. An agreement by the foundation to pay a government official, other than an agreement to employ the official for any period after the termination of his government service, if the official terminates his government service within a 90-day period.

Disqualified persons (also defined in Section 4941) are the donor; the trustee; family members (which include the grantor's spouse, ancestors, children, grandchildren, great-grandchildren and the spouses of these individuals); and controlled business organizations (those in which 35% or more of the ownership interest is controlled by disqualified persons).

The tax code makes the private foundation self-dealing rules applicable to CRTs and CLTs. This essentially prohibits all transactions between a CRT or CLT and the donor (and the donor's family) and any business in which the donor and his family have a 35% or greater ownership interest.

Planning Tip: Charities are not disqualified persons, so the remainder charity could purchase something from the trust and that would not cause a self-dealing problem.

Planning Tip: Self-dealing does not apply to transactions involving gift annuities that are maintained only by public charities. This makes gift annuities an important planning tool in business succession planning.

Conclusion

Incorporating charitable planning tools in business exit planning provides unique opportunities for the business owner who is already interested in charitable giving, as well as providing excellent opportunities for the professional advisors to work together.

The 2013 3.8% Surtax

A new 3.8% surtax on certain investment income starts January 1, 2013, as part of the health care reform act. While that's a couple of years away, it is not too early to start planning for it, because there are steps clients can take this year that will help reduce or even eliminate it. This post explains the Surtax. 

The 3.8% investment income surtax, also called the health care surtax or the Medicare tax, applies to tax years ending after December 31, 2012. The surtax is:

For individuals, 3.8% of the lesser of:

1. net investment income for such taxable year, or
2. the excess, if any, of
1. the modified adjusted gross income for the year, over
2. the threshold amount.

For trusts and estates, 3.8% of the lesser of:

1. the undistributed net investment income for the year, or
2. the excess, if any, of
1. the adjusted gross income (as defined in Code Section 67(e)) for the year, over
2. the dollar amount at which the highest tax bracket in Code Section 1(e) begins for the year ($11,200 in 2010).

There are three numbers that determine how this surtax will affect you.


Net Investment Income

This is the sum of gross investment income over allocable investment expenses. For purposes of this surtax, investment income includes interest, dividends, capital gains, income from annuity payments, rents, royalties and passive activity income.

Investment income does not include active trade and/or business income; any of the income sources listed above (e.g., interest, dividends, capital gains, etc.) to the extent it is derived in active trade and/or business; distributions from IRAs and other qualified retirement plans; or any income taken into account for self-employment tax purposes.

For the sale of an active interest in a partnership or S-corporation, gain is included as investment income only to the extent net gain that would be recognized if all of the partnership/S-corporation interests were at fair market value.

Modified Adjusted Gross Income (MAGI)

Here, MAGI is the sum of adjusted gross income (the number from the last line on page 1 of Form 1040) plus the net foreign income exclusion amount.

Threshold Amount

Married taxpayers filing jointly . . . $250,000
Married taxpayers filing separately . . . $125,000
All other individual taxpayers . . . $200,000
Trusts and estates . . . Beginning of the top bracket (which, for reference purposes only, is $11,200 for 2010)

What would a conservation easement do for me?

The conservation easement is an agreement that permanently restricts the future development or use of your land. You may do this to preserve your land and maintain it in its current condition so that it is preserved for future generations although it may allow limited development. The tax benefits can be significant. Upon donating an easement, you obtain an immediate income tax deduction. At your death, the property is valued for estate tax purposes at a lower value since the development rights have been given away. This may enable your family to keep property they might have been forced to sell to pay the taxes.

Avoiding the 3.8% Surtax

Today, I hosted an excellent Advisor's Forum teleconference on avoiding the 3.8% surtax presented by Bob Keebler, CPA.  The surtax kicks in in 2013, and is an additional 3.8% tax on certain high income earners.  The tests for whether or not a person will incur the tax are rather complex, but not terribly complicated.

Will you be subject to the Surtax?

First, you must meet the income threshold before the tax is incurred, the Surtax Threshold.  The thresholds are $200,000 for inviduals, $250,000 for married couples, $125,000 for married filing separately, and $11,200 for trusts and estates.  The threshold is met if your Modified Adjusted Gross Income (MAGI) exceeds the proscribed levels.  For most taxpayers, the MAGI will be the same as Adjusted Gross Income, which is gross taxable income less above the line deductions.


If your income (MAGI) exceeds the threshold in 2013 and later, then you might owe the tax.  The next test is you must have Net Investment Income.  Net Investment Income is essentially taxable investment income less costs incurred to generate that income.  If you have net investment income, then the 3.8% Surtax will apply to the lesser of your Net Investment Income or the excess of your MAGI over the threshold amount.

Examples:

1. Alice, a single person with $500,000 of wages income, with no investment income, will not be subject to the Surtax.
   
2. Bob, a single person with $400,000 of wages income and $100,000 of net investment income, will owe the 3.8% Surtax on the entire $100,000 of his net investment income.
3. Cathy, a single person with $100,000 of wages income and $400,000 of net investment income, will owe the 3.8% Surtax on $300,000 of her net investment income.

Notice the total income in all three examples is the same, but Alice pays $0 Surtax, Bob pays $3,800 of Surtax, and Cathy pays $11,400 in Surtax.  Cathy did not owe Surtax on ALL of her net investment income because the Surtax is limited to the lesser of her Net Investment Income ($400,000) and the excess of her MAGI ($500,000) over the Surtax Threshold ($200,000).   $500,000 - $200,000 = $300,000 subject to the Surtax.


Ways to avoid the Surtax


The simplest ways to avoid the Surtax is to avoid taxable investment income.  Without it, there can be no Surtax imposed.  This means investing in Muni Bonds, Life Insurance, Annuities, IRAs. 


If you will have taxable investment income, you can minimize your tax by minimizing your MAGI.  Traditional IRA distributions will increase your MAGI, but Roth IRA distributions will not.  This makes a strong case for many taxpayers to convert their IRAs to Roth in 2010, 2011, and/or 2012.

Why does this tax exist?

I really do not get this tax.  I am not sure how much thought goes into tax legislation.  The claim is this tax is designed to help pay for the Health Care Bill.  While that may be the justification of the tax, I am very skeptical it will meet that goal, and consequently, I am just not sure if that is its purpose.  Because tax legislation is more driven by politics than logic, it is often unclear whether the behaviors of Americans that are driven by tax laws are by design or by accident.  Impact studies seem to assume that taxpayers will not modify their behaviors, and if they do not, the study provides a decent look into what the tax cost or revenue to the goverment is.  Of course, taxpayers do change their behavior based on the tax laws.  So I see its justification as a means to increase revenue to pay for the Health Care Bill as suspect. 


This tax is fairly easy to avoid, which makes it look more like social engineering than a revenue producer.  This tax clearly favors wage earners over investers.  If it disfavors investing, does that make the tax designed to promote spending over investing?  Money spent doesn't generate future investment income, and therefore avoids the Surtax.  The Surtax further favors tax-free investments over taxable investments, so maybe it is designed to encourage taxpayers to lend money to the government.  It encourages investing through life insurance for tax-free investing and annuities for tax deferred investing.  It favors growth investing over investing for dividends, as there is no Surtax on unrecognized gains.  It encourages investing in oil & gas.

Retirement Accounts

No matter the amount of your retirement assets, proactive planning is critical because of the sometimes confiscatory taxes these assets are subject to – up to 70% or more in certain circumstances. As you may know, traditional retirement assets are not subject to income tax until withdrawal – and because the withdrawals consitute income, the larger the withdrawal, the higher the tax rate. If you’re like many of our clients, you want these assets to grow to the maximum extent possible, since assets not taxed until withdrawal grow much faster than assets that are taxed every year.

There are several strategies that can help you defer and perhaps eliminate the tax liability of these hard-earned assets, while at the same time legally protecting them from the creditors of your loved ones. These strategies can also help you coordinate your retirement plans with your overall estate and financial planning objectives to ensure that those objectives are met.

Retirement Plan Trust Planning can hep ensure maximum stretchouts but must be done carefully to avoid a requirement of early distributions.

Roth Conversions

Since last fall, Roth IRA conversion enthusiasm has been high. However, over the last couple of months that enthusiasm has cooled off quite a bit because of weak market conditions. Despite the lull in the market (in fact, because of the lull in the market!), now more than ever is a good time for a person to look at converting to a Roth IRA, especially if one is optimistic about the market rebounding. Even if the market fails to rebound, a person can still “undo” (i.e. recharacterize) his/her conversion and generally be in no worse position than if no conversion was done at all.

the-case-for-filing-your-taxes-late: Personal Finance News from Yahoo! Finance

 

the-case-for-filing-your-taxes-late: Personal Finance News from Yahoo! Finance