Recent
Tax Acts and Legislation Affect Tax, Estate and Financial Planning
By:
CONTENTS
Tax
and Related Changes Abound
Selected
Payroll, Payroll Tax and Related Provisions
Payroll
Tax Holiday for New Workers
Credit
for Providing Health Insurance Coverage to Certain Employees
Increased
Medicare Tax on High Income Earners
Expansion
of Medicare Tax to Passive Income
Application of Medicare Tax on Investment
Income of Trusts and Estates
Planning Considerations for Medicare Tax on
Investment Income
Medical
Expense Deductions Restricted
Economic
Substance Doctrine Toughened
History
of the Economic Substance and Related Doctrines
Complications
and Uncertainty Remain
Exclusion
of Gain on Small Business Stock
Reporting
for Real Estate Expanded
Bottom
Line: Three Tough GRAT Changes
Overview
of Traditional GRAT Planning Under Current Law
Recent
Tax Acts and Legislation Affect Tax, Estate and Financial Planning
IRS Circular 230
Legend: Any advice contained herein was
not intended or written to be used and cannot be used, for the purpose of
avoiding U.S. Federal, State, or Local tax penalties. Unless otherwise specifically indicated
herein, you should assume that any statement in this communication relating to
any U.S. Federal, State, or Local tax matter was not written to support the
promotion, marketing, or recommendation by any parties of the transaction(s) or
material(s) addressed in this communication.
Anyone to whom this communication is not expressly addressed should seek
advice based on their particular circumstances from their tax advisor.
Tax and Related Changes Abound
Congress is at it again. Proposing, and sometimes passing, tax legislation, at a rapid clip. Some of the many recent developments include:
- The
Hiring Incentives to Restore Employment Act (H.R. 2847).
- 2010 Health Care Act (PL 111-148,
- 2010 Reconciliation Act.
- The
Patient Protection and Affordable Care Act (3/23/10).
Also,
The House of Representatives passed the Small Business and
Infrastructure Jobs Tax Act of 2010 on March 24 (H.R. 4849).
This torrent of new and proposed legislation assures complexity and difficulty in tax planning. Perhaps the only thing that will be certain in tax planning for the near term, is complexity, more change and more difficulties. New developments will likely obsolete this update outline before you read it.
Instead of resolving estate tax uncertainty, and simply raising marginal income tax rates to raise revenues, Congress is using its old tricks of “a little twist here, a little twist there” to start addressing budget issues. Congress has (well at least as of the day this is being written, but who knows) failed to address the estate tax morass. The problem with many quirky tax increases approach is that taxpayers resent these types of changes because they are difficult to understand and harder to plan for. While simply raising tax rates would be direct and honest, it obviously is not politically palatable.
Selected Payroll, Payroll Tax and
Related Provisions
Recent tax legislation
has included a blizzard of incentives to encourage employment, defray the cost
of health care coverage and more. The following discussion is but a brief
overview of some of the many changes.
Payroll Tax
If an employer adds new employees to their payroll they may qualify for a payroll tax holiday during which the employer payments for Social Security taxes will be waived. To qualify, the worker must certify to the employer that he or she has not worked for more than 40 hours during the 60 days prior to starting work for you. Form W-11 can be used to obtain the employee's confirmation that he or she meets the requirements of being a qualified employee.
Credit for Providing Health Insurance Coverage to Certain Employees
Businesses can earn a tax credit for their payments for certain health insurance premiums. Act, signed March 23, 2010.
The maximum credit is 35% of premiums paid in 2010 by eligible small business employers (25% for tax-exempt employer organizations). In 2014, this maximum credit increases to 50 percent of premiums paid by eligible small business employers (35% for tax-exempt organizations). Low and moderate income workers are the target for this credit. There are three requirements to qualify:
(1) The employer must employ less than 25 full-time equivalent employees. To assure complexity the new acronym “FTE” has been created for “full-time equivalent” employees.
(2) The employer must pay wages averaging less than $50,000
per employee, per year.
(3) The employer must pay for insurance premiums under a qualifying arrangement. This means that the employer pays premiums for each employee enrolled for health care coverage offered by the employer. The amount paid must be equal to a uniform percentage (which cannot be less than 50%) of the premium cost of the coverage.
Employers with 10 or fewer full-time equivalent employees paying average annual wages of $25,000 get the maximum credit. The credit is phased out as the employer’s average wages increase from $25,000 to $50,000, and as the number of full-time equivalent workers increases from 10 and 25. The FTE worker concept can be illustrated by 40 employees working ½ a week each are equivalent to 20 full-time workers.
If the number of FTEs exceeds 10 or if average annual wages exceed $25,000, the amount of the credit is reduced as follows (but not below zero). If the number of FTEs exceeds 10, the reduction is determined by multiplying the otherwise applicable credit amount by a fraction, the numerator of which is the number of FTEs in excess of 10 and the denominator of which is 15. If average annual wages exceed $25,000, the reduction is determined by multiplying the otherwise applicable credit amount by a fraction, the numerator of which is the amount by which average annual wages exceed $25,000 and the denominator of which is $25,000. In both cases, the result of the calculation is subtracted from the otherwise applicable credit to determine the credit to which the employer is entitled. For an employer with both more than 10 FTEs and average annual wages exceeding $25,000, the reduction is the sum of the amount of the two reductions. This sum may reduce the credit to zero for some employers with fewer than 25 FTEs and average annual wages of less than $50,000.
Importantly for closely held businesses, the owner of the business also provides services to it, does not count as an employee. Thus, a sole proprietor, a partner in a partnership, a shareholder owning more than two percent of an S corporation, and any owner of more than five percent of other businesses, are not considered employees for purposes of the credit. Thus, the wages or hours of these business owners and partners are not counted in determining either the number of FTEs or the amount of average annual wages, and premiums paid on their behalf are not counted in determining the amount of the credit.
This health insurance credit is claimed as part of the general
business credit. The Patient Protection and Affordable Care
Increased Medicare Tax on High
Income Earners
Currently, wages are subject to a 2.9% Medicare payroll tax. Workers and employers each pay ½, or 1.45%. If you’re self-employed you pay it all but get an above- the- line income tax write-off for ½. This Medicare tax is assessed on all earnings or wages without a cap. These taxes fund the Medicare hospital insurance trust fund which pays hospital bills for those 65+ or disabled. Starting in 2013 an additional .9% Medicare tax will be imposed on wages and self-employment income over $200,000 for singles and $250,000 for married couples. IRC Sec. 3101(b)(2). That makes the marginal tax rate 2.35% for employees. Self-employed persons will face a 3.8% rate on earnings over the above amounts.
Look for more changes like this, a few percent here, a few percent there instead of just the rate increases needed to raise revenues. The result will make tax planning and preparing projections increasingly complex.
By way of perspective, taxpayers should bear in mind that the Medicare tax is in addition to the Old Age, Survivors and Disability Insurance (OASDI) and Federal Insurance Contributions Act (FICA) taxes which apply to employers and employees. The OASDI rate is 6.2% on wages up to $106,800 (2010). That ceiling is increased yearly.
Expansion of Medicare Tax to Passive
Income
Only wages and
earnings are subject to the Medicare tax above, but starting in 2013 the 3.8% Medicare
tax will apply to net investment income if your adjusted gross income (
These amounts are
not supposed to be indexed so inflation will erode these thresholds overtime. Failure
to inflation adjust these amounts is a significant departure from many prior
tax law changes. Over time these caps and the tax raise will shift from
applying to the wealthiest sliver of taxpayers to a broader range of taxpayers,
just like the
Net investment
income includes interest, dividends, royalties, rents, gross income from a
passive business, and net gain from property sales. Income from a trade or
business will not be included in definition of net investment income. IRC Sec. 1411(c).
Application of
Medicare Tax on Investment Income of Trusts and Estates.
This new tax will
apply to the unearned income of individuals, as well as to estates and trusts. IRC Sec. 1411(a)(2). An estate or trust will
actually pay the Medicare tax on investment income based on the lesser of the
estate or trust’s undistributed net investment income, or the excess of the
estate or trusts net investment income over the threshold at which the estate
or trust is taxed at the highest marginal tax rate. In 2010 that figure is
$11,200. However, unlike the thresholds for applying the increased Medicare
taxes, this figure for estates and trusts is inflation indexed. The
calculations for an estate and trust will be complicated by having to determine
expenses that can offset investment income with consideration to the rules
under Code Section 67(e) and the special rules for applying the 2%-of-
Will it become
advantageous to distribute money from a larger estate or trust to the
beneficiary quicker to avoid the surcharge? If an estate or trust earns $30,,000
it will face the additional Medicare tax. However, a beneficiary who is
entitled to a distribution from the estate, or who holds an interest in the
trust, may not have, even with the full distribution of his or her share of the
estate or trust, enough income above the threshold to trigger the Medicare
investment tax.
Will the fiduciary
face a different analysis in determining whether or not to hold assets in the
estate or trust if doing so will increase the tax cost? Perhaps an executor is
favoring delaying distributions to a later calendar year pending receipt of a
tax clearance letter, or confirmation of the exact amount of a liability. Those
decisions should be documented if the delay may trigger the additional tax.
Instead, the fiduciary could perhaps distribute the funds prior to year end,
reducing the fiduciary income to a level below the threshold at which the
Medicare investment tax will apply, and have the beneficiaries sign receipts,
releases and refunding bonds agreeing to refund the distribution to the estate
if the funds are needed for the uncertain liability. This puts the fiduciary
between the proverbial rock and the hard place. If the fiduciary distributes
funds needed for covering expenses the fiduciary might face personal liability.
However, if the fiduciary does not make the distribution the funds will be
potentially taxed at a higher rate and the fiduciary could face claims from the
beneficiaries.
Some trusts will be
exempt from the Medicare investment tax. These include charitable trusts exempt
from tax under Code Section 501 and charitable remainder trusts (CRTs) exempt
from tax under Code Section 664. Grantor trusts, and simple trusts that
distribute all income (or a complex trust that distributes all income) will not
face the tax. But that is of little solace as the grantor or other
beneficiaries may face the Medicare tax on investment income.
Planning
Considerations for Medicare Tax on Investment Income
Planning will be
more complex. Consider some of the following possibilities:
- You can
reduce net investment income by properly allocable deductions. Existing rules that determine how you
allocate deductions to municipal bonds and other tax exempt income could
be used, or other regulatory guidance might be provided.
- Your advisers
may have to allocate their bills by category to help.
- Investment
income derived as part of a trade or business is not subject to the new
Medicare tax on investment income. Does that mean that if you retain
liquid assets and the income they generate inside your business that the
tax will be avoided? Likely not unless the business can justify a business
purpose for this. Although there are no rules or guidance yet, creating
minutes documenting the business purpose of retaining investment assets in
the business might be one of the steps to take to support this type of
action. However, one downside for this type of planning will be exposing
liquid assets to business creditors and claimants.
- This
extension of the Medicare tax won’t apply to distributions from retirement
plan assets. IRC Sec. 1411(c)(5). Roth IRAs are perhaps even a better
result that initially thought. Earnings on non-IRA investments could be
subject to this higher tax, but if used to pay tax on a Roth conversion
the earnings will all be inside the tax deferred Roth thereafter.
- If you earn a
salary from an active business the Medicare tax will apply without limit.
If you receive a dividend from a passive business the Medicare tax (once
the threshold is passed) will apply without limit. But what if you shift
income from salary or profits distributions to dividends from an active
business. Will those payments escape the increased Medicare tax on all
fronts?
- Passive real
estate, as defined under the existing passive loss rules of Code Section
469 could be adversely impacted. Great timing, just as commercial real
estate is facing some of the most daunting economic challenges in recent
memory. There might be some incentive for real estate owners to
re-evaluate their status under the passive loss rules.
- Hug your
insurance agent. Yes, the cash build up inside an insurance policy will
remain protected. Coupled with the expectation of most tax advisers that
income tax rates on the wealthy will continue to rise and the estate tax
will return, permanent life insurance inside an irrevocable life insurance
trust is looking quite handsome. However, it does appear that life
insurance surrenders and sales will be taxed, along with the realization
(i.e. cash out) of the inside build-up of the cash value policy in excess
of the policy-holder’s basis. Rev. Rul. 2009-13.
- How will
passive versus active distinctions for businesses be determined and what
impact will this have on the structure of business and investments? The
definitions under the passive loss rules of Code Section 469 will
apply. IRC Sec. 1411(c)(2)(A).
Cool. That leaves us all with complete uncertainty as to how these rules
will apply to trusts. There are two authorities on the issue, and well,
they reached polar opposite answers. In Mattie K. Carter Trust v. US the trust managed various assets,
including the Carter Ranch which involved cattle, oil and gas. The trustee
hired a ranch manager and other employees to carry out most ranching
duties. The Service argued that only the trustee’s efforts should be
considered in determining if the trust met the test of materially
participating in the ranch. The trustee’s position was that the trust’s
material participation in the ranching activity should be evaluated with
consideration to the efforts of not only its fiduciaries, but also its
employees and agents. The U.S. District Court for the Northern District of
Texas determined that the law did not mandate that only the trustee’s
activities could be considered. In the aggregate, the efforts of the
trustee, ranch manager and others, showed regular, continuous and substantial
involvement so that the trust was deemed to materially participate and
could deduct the losses. 256 F. Supp. 2d 536 (
- How will
investment location decisions be made? Will it become more advantageous
for high income taxpayers to retain income assets inside the tax
protective envelope of qualified plans? Will the calculus of investing in
tax exempt versus taxable bonds change? Income from tax-exempt municipal
bonds will not be subject to the Medicare tax. For wealthy taxpayers with
variable year to year income the determination may not be easy or
consistent from year to year.
- Using
charitable remainder trusts (CRTs) and non-grantor charitable lead trusts
(CLTs) will shift investment income to the trust formed and avoid the new
Medicare investment income tax.
- When planning
to harvest gains and losses on security positions this new tax might enter
into the analysis. Shifting deductions to the extent feasible to control
investment income from year to year, using installment sales and tax
deferred Code Section 1031 exchanges might keep you below the threshold.
The 3.8% tax is in addition to the increased Medicare rate of .9% on earnings discussed above so the surcharge for higher earning taxpayers begins to near 5%. This increased marginal rate will have an impact on net of tax calculations for budgets, investments, etc.
The unfortunate bottom line with this type of micro tax change is that while it will be costly, the cost in terms of professional fees and effort of planning around it may be greater than the benefit to many taxpayers.
Medical Expense Deductions Restricted
Raising revenue by taxing those struggling with substantial
medical expenses is an immoral and outrageous act, but that is part of what
Congress has done! Review the statistics on personal bankruptcy and you’ll find
that a large portion of personal bankruptcies are not due to folks buying a new
Hummer who should be in a used Chevy, but rather good people struggling with
costly medical bills. But the folks in
Under current law, you can only deduct, as an itemized deduction, medical expenses to the extent that they exceed 7.5% of your adjusted gross income (AGI). This restriction is in addition to the others that limit the tax benefits of itemized deductions. That never made much sense. But, why stop when the rules are senseless and unfair. Make ‘em worse. So starting with 2013 you’ll only be able to deduct medical expenses as an itemized deduction if they exceed 10% of your AGI. IRC Sec. 213. As an attempt to show some compassion, Congress provided that for folks 65+ the 7.5% rule will remain in place until the end of 2016. Why does age alone correlate with a better medical expenses break? What of the millions suffering at young ages with substantial medical costs?
For some the new change won’t mean much as the 10% threshold
that applies for alternative minimum tax (
The new tax regime might encourage some fence-sitting high income couples to avoid marriage if their combined earnings will trigger the additional tax costs and further reduce medical deductions.
Taxpayer employees will be responsible for the additional Medicare tax on wages. IRC Sec. 3102(f)(2). Employers will not be able to determine for many employees if the extra tax is due because it is the combined income of the married couple, not only the income of the employee involved, that determines if the additional tax applies.
Many of the proposed changes might make it more difficult for taxpayers to monitor the minimum that is required to be paid in order to avoid penalties for underpayment of estimated income taxes by paying in 100% of prior year’s tax liability or 90% of the current year’s tax liability. IRC Sec. 6654(m). For many taxpayers, it will be difficult to ascertain their marginal tax rate, availability of medical deductions, etc. until calculations are made following the end of each tax year. This will be especially problematic for business owners whose income depends on business developments rather than a fixed salary. Bottom line, many taxpayers who had made calculations for estimated tax purposes will just default to the 100% (or 110% at higher levels of adjusted gross income) of prior year safe harbor.
Economic Substance Doctrine Toughened
The tax law has long included economic substance concepts for transactions to be respected. For a transaction to be respected under current law it should generally have economic substance apart from the hoped for tax benefits and a business purpose. New Section 7701(o), enacted by Section 1409 of the new act codifies as statutory law the economic substance doctrine that heretofore had relied on inconsistent case law for its application.
History of the Economic Substance and Related
Doctrines
The Committee Reports stated that the: “…courts have
developed several doctrines that can be applied to deny the tax benefits of a
tax-motivated transaction, notwithstanding that the transaction may satisfy the
literal requirements of a specific tax provision. These common-law doctrines
are not entirely distinguishable, and their application to a given set of facts
is often blurred by the courts, the
The economic substance doctrine under case law was applied
to deny tax benefits arising from transactions that did not result in a
meaningful change to the taxpayer's economic position other than a purported
reduction in Federal income tax. See, e.g., ACM Partnership v. Commissioner,
157 F.3d 231 (3d Cir. 1998), aff'g 73 T.C.M. (CCH) 2189 (1997), cert. denied
526
A common law doctrine that often is considered together with the economic substance doctrine is the business purpose doctrine. The business purpose doctrine involves an inquiry into the subjective motives of the taxpayer — that is, whether the taxpayer intended the transaction to serve some useful non-tax purpose. In making this determination, some courts have bifurcated a transaction in which activities with non-tax objectives have been combined with unrelated activities having only tax-avoidance objectives, in order to disallow the tax benefits of the overall transaction. See, ACM Partnership v. Commissioner, 157 F.3d at 256 n.48.
The new law endeavors to clarify these “blurs” and toughen the rules considerably. IRC Sec. 7701(o).
New Code Section 7701(oError!
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If the economic substance doctrine is relevant to a transaction, the transaction will only pass the economic substance test if only both of the following requirements are met:
1. The transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and
2. The taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction. IRC Sec. 7701(o)(1)(A) and (B).
The Committee Report commented: “Key to [the determination of whether a transaction has economic substance] is that the transaction must be rationally related to a useful nontax purpose that is plausible in light of the taxpayer's conduct and useful in light of the taxpayer's economic situation and intentions. Both the utility of the stated purpose and the rationality of the means chosen to effectuate it must be evaluated in accordance with commercial practices in the relevant industry. A rational relationship between purpose and means ordinarily will not be found unless there was a reasonable expectation that the nontax benefits would be at least commensurate with the transaction costs.”
Now the fun begins. How do you determine if a transaction
might have a substantial purpose apart from the tax effects? Well here’s the
definition of the new law: The potential for profit of a transaction shall be
taken into account in determining whether the requirements above are met with
respect to the transaction only if the present value of the reasonably expected
pre-tax profit from the transaction is substantial in relation to the present
value of the expected net tax benefits that would be allowed if the transaction
were respected. IRC Sec. 7701(o)(2)(A). Notice that completely absent from this
test are some of the most important non-tax motivators for folks to engage in
what is loosely and broadly referred to as “estate planning.” These major
motivators include control over assets, asset protection from lawsuits of the
parent/benefactor and heirs/donees, divorce protection, and so on. OK, how is
the profit potential weighed? Must the business have projections? How many
successful start up companies started in someone’s garage with about the
formality of a pair of jeans and a torn T-shirt? If projections of expected
profits are estimated, what type of cost will be incurred to have an accountant
issue the report in accordance with appropriate standards? Will a projection
prepared by the taxpayer informally suffice? What discount rate is appropriate?
What if the projections aren’t realized? If the projections aren’t realized, or
even prove rather inappropriately rosy, will that seal the deal for the
How much profit must be anticipated? The Committee Report stated: “if a taxpayer relies on a profit potential, the present value of the reasonably expected pre-tax profit must be substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected.”
But wait, some tax benefits were expressly enacted to stimulate activity desired by Congress. The low income housing tax credit is a prime example. These credits are typically purchased by investments by large C corporations not subject to the passive loss limitations. The only motivation for the transactions is the economic impact of the low income housing credit. That should be a permissible goal because that is precisely what Congress intended the low income housing credit to accomplish. The Committee Report recognized this: “Thus, for example, it is not intended that a tax credit (e.g., section 42 (low-income housing credit), section 45 (production tax credit), section 45D (new markets tax credit), section 47 (rehabilitation credit), section 48 (energy credit), etc.) be disallowed in a transaction pursuant to which, in form and substance, a taxpayer makes the type of investment or undertakes the type of activity that the credit was intended to encourage.” But will this concept extend further? Will losses created by bonus depreciation or Section 179 elective expensing be considered sanctified as well?
The complications continue. The new provision provides that fees and other transaction expenses shall be taken into account as expenses in determining pre-tax profit under the above test. The Treasury has been instructed to issue regulations explaining this gobblygook.
Say you wanna get cute and structure a deal to take advantage of state or local income tax benefits. Excuse me, does anyone start a business ignoring their accountant’s plea to save state income tax if feasible? Well, the effect of state and local tax benefits will be treated in the same manner as a Federal income tax effect. However, some commentators differentiate state and local tax savings which result from shifting income to a lower tax state as being a valid economic purpose. These are distinguished from mere home state tax savings.
Achieving a financial accounting benefit shall not be taken into account as a purpose for entering into a transaction if the origin of such financial accounting benefit is a reduction of Federal income tax. However, a transaction that was motivated by a favorable accounting impact, so long as that positive was not a function of a federal tax savings, could be a valid business purpose.
The term ”economic substance doctrine“ means the common law doctrine under which tax benefits under subtitle A of the Code with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.
In the case of an individual, the above economic substance test shall apply only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income. This exception might be so narrow as to provide little practical benefit to transaction entered into for asset protection, control, and other personal reasons since they are normally structured to be akin to a trade or business or production of income venture. Further, since an individual cannot generally deduct depreciation, amortization and other expenses not expressly permitted as itemized deductions absent a trade or business or production of income status, many transactions will be pushed under the new test by taxpayers themselves endeavoring to achieve these tax benefits. This appears to be the classic “damned if you do and damned if you don’t” for taxpayers. If a taxpayer argues that a particular endeavor is not a trade or business he will lose deductions. If the taxpayer argues that the endeavor is a trade or business in order to claim deductions he may have successfully made the case for the IRS that the new economic substance rules apply.
The term “transaction” includes a series of transactions. Thus, the step transaction doctrine may be applied to collapse a series of transactions to determine the true economic and profit motive impact.
The new law also enhances penalties applicable for underpayments of tax attributable to transactions lacking economic substance under the new rules described above. Specifically, any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law will be subject to penalties under Code Section 6662. An underpayment of tax attributable to one or more nondisclosed noneconomic substance transactions may be subjected to a 40% penalty. A “nondisclosed noneconomic substance transaction” means any portion of a transaction described in subsection (b)(6) with respect to which the relevant facts affecting the tax treatment are not adequately disclosed in the return nor in a statement attached to the return.
Although many tax penalties can be abated if the taxpayer can show reasonable cause, this will not get you out of the hot water if you violate the economic substance rules.
The Committee Report notes certain transactions that should be excluded. “The provision is not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages. Among these basic transactions are (1) the choice between capitalizing a business enterprise with debt or equity; (2) a U.S. person's choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; and (4) the choice to utilize a related-party entity in a transaction, provided that the arm's length standard of section 482 and other applicable concepts are satisfied. Leasing transactions, like all other types of transactions, will continue to be analyzed in light of all the facts and circumstances.”
Complications and Uncertainty Remain
The Committee Report states that “The provision provides a uniform definition of economic substance, but does not alter the flexibility of the courts in other respects.” Thus, the economic substance test, although tougher, will nevertheless remain a matter of facts and circumstances and court interpretation. This fact seems to belie the certainty the provision was intended to achieve.
Exclusion of Gain on Small Business Stock
Under current law, non-corporate taxpayers can exclude 50% or 75% of the gain on the sale or exchange of qualified small business stock held for more than five years. IRC Sec. 1202. H.R. 4849 increases the exclusion percentage to 100% for qualified stock acquired after March 15, 2010 and by the end of 2010.
A qualified small business corporation is a domestic C corporation that meets the following requirements:
- Assets are $50 million or less, and the corporation agrees to report compliance with this requirement to the IRS.
- The shareholders generally have to acquire the corporation’s stock as an original issue in exchange for money or property, or as compensation.
80% or more of the value of the corporation’s assets are used in a qualified trade or business. This excludes the provision of personal or professional services, rental property, farming, a DISC, RIC, etc.
Reporting for Real Estate Expanded
Taxpayers renting real estate will be subject to additional information reporting requirements. If you make payments of $600 or more to a service provider, such as a plumber, the CPA who does your tax return, etc. in the course of earning rental income you will have to file a Form 1099 reporting those payments. Previously, only landlords involved in a trade or business had to comply with these rules. Renting your summer home or vacation condo? These rules will apply to you.
New Anti-GRAT RulesError!
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The House of Representatives passed the Small Business and Infrastructure Jobs Tax Act of 2010 on March 24 (H.R. 4849) that, if enacted, will make three changes to the GRAT technique. While these are less severe than a repeal of GRATs, they really can take a lot of the planning benefits out of the GRAT technique. Grantor retained annuity trusts, or “GRATs”, have been a choice tool of estate planners.
The new GRAT restrictions will be effective for
gifts and transfers made after the date of enactment. So if you could benefit
from a short term GRAT, move quickly. If you might be able to use a larger
dollar GRAT, e.g., for a substantial family business interest, it may be
worthwhile pushing forward quickly.
Bottom Line: Three Tough GRAT Changes
The tax proposal adds three requirements for gifts
to a GRAT to qualify for the favorable gift tax treatment. Without this special
treatment clients would be taxed on 100% of the value of the assets given to a
GRAT under the valuation rules of Chapter 14 of the Internal Revenue Code.
After a quick review of what a GRAT is and does to
set the foundation, each of these changes, and their implication to planning
for your clients, will be discussed.
Overview of Traditional GRAT Planning Under Current
Law
Although most advisers are likely familiar with GRATs, a quick overview of the technique and how it use to be used, will make the explanation of the changes clearer.
Current tax rules include tough rules for valuing certain transfers in trust of
interests in property for fixed time periods (e.g. annuity interests and
remainder interests). Bottom line, if your client makes a transfer to a trust
to benefit a family member and retains any interest in the property
transferred, the
So before the proposed new rule changes, a typical GRAT plan might look like
the following hypothetical:
- Transfer $1 million to four different GRATs each lasting for two years.
- Each GRAT will be invested with a single and different
volatile asset class. This might not mean any change in the client’s
overall asset allocation strategy, rather a shift in the location of particular
investments. All this should be reflected in the client’s and each trust’s
investment policy statement (
- The GRATs are set up to make high 50%+ annuity payments to you as the grantor each year so that the present values of the gifts to the GRATs are zero for gift tax purposes.
- If one GRAT realizes a substantial increase in value, you as the grantor will exchange non-volatile assets such as cash or Treasuries for the volatile securities, thus locking in or immunizing that gain inside the GRAT. This is the very power (of substitution) that is used to assure grantor trust income tax status for the GRAT.
- You take the assets received for the annuity payments or the exchange and transfer them to new 2-year GRATs and keep the plan rolling.
- The end result is that winning GRATs transfer huge value outside your estate with no gift tax cost. Losers have no downside and are just cycled through more GRATs until they produce extraordinary gains above the imputed tax law interest rate under Code Section 7520.
How does a GRAT win? The value of the client’s gift for gift tax purposes is determined at the time of the initial transfer to the GRAT. If the GRAT property grows at a rate in excess of an interest rate mandated by the tax laws (the so called, “Section 7520” rate), the excess appreciation passes to the remainder beneficiaries (an insurance trust, e.g. to provide a payoff strategy for a split-dollar arrangement, or to another grantor or defective trust to continue the income tax burn for the grantor) without further gift tax consequences to the grantor. Since today’s interest rates are still at historic lows, the bar GRATs have to exceed to be successful is also very low by historical standards.
The new tax proposal adds certain requirements
which will effectively make the GRAT technique less useful for some taxpayers,
and perhaps useless for others.
·
Gift Value Greater
than Zero. In the previous example, you saw that a GRAT could be
structured so that for gift tax purposes the transfer to the GRAT had a present
value of zero. Although the law seemed pretty clear on that, many tax advisers
structured GRATs with a modest current gift value so that it could be reported
as a gift on a gift tax return. So what does this new rule mean? Only time will
tell, but it could well turn out to be a tax planning disaster if rumors
circulating that the
·
10-Year GRATs. The
retained annuity interest must have a term of not less than 10 years. If a GRAT
has to last at least 10 years it substantially increases the mortality risk of
using the GRAT technique. For older or infirm clients, that might eliminate
GRATs entirely from their planning arsenal. For many clients, GRATs will
increasingly be paired with 10-year term life insurance policies held in
irrevocable life insurance trusts. This will be similar to the common pairing of
charitable remainder trusts and life insurance inside a separate insurance
trust. But the impact is even more significant. Even for younger clients the 10
year the strategy of short term rolling GRATs which was the keystone of the
technique for removing upside volatility from the client’s estate, won’t work.
You cannot swap out volatile securities and sit on cash for most of a 10 year
period. Fine tuning asset location decisions and accepting a little less bang
for the GRAT buck will be the norm.
·
No Declining GRAT Payments. This rule will prevent an end run around the 10 year
rule. If you sufficiently front loaded all the GRAT payments in the first year
or two the final eight years would be a tail that wouldn’t have much impact.
The Hiring Incentives to Restore
Employment Act (H.R. 2847) was signed into law on
· Beneficiaries of a non-grantor foreign trust that has current or accumulated income may have to recognize income from the use of property owned by that trust.
·
Reporting requirements have
been beefed up. The FBAR rules, that have received so much attention lately,
have been expanded. Now taxpayers will also have to report certain interests in
foreign entities, custodial accounts at foreign financial institutions; certain
foreign stocks and securities, and interests in foreign investment funds or
derivatives with a foreign counterparty. A
·
If a