The American Taxpayer Relief Act of 2012 (which became law on January 2, 2013) made permanent the temporary estate/gift/generation-skipping transfer tax exemptions established in December 2010, increased the rate on non-exempt estates/gifts/generation-skipping transfers to 40% and introduced substantial new income tax burdens on high income taxpayers and trusts. In addition, 2013 is the year in which both of the Medicare surtaxes of the Patient Protection and Affordable Care Act of 2010 (sometimes referred to as “Obamacare”) kick in. As a result, many wealth planning professionals will be doing more income tax planning, and estate tax planning will become less of a driving force.

In this edition of The Wealth Counselor, we will examine some of the new income tax provisions clients will face in 2013 and beyond and potential planning opportunities that remain in light of these provisions, as well as some different ideas to consider.

Classic Income Tax Planning
Classic strategies for income tax planning have long included:

*    Maximize deductions
*    Reduce ordinary income to achieve capital gain
*    Invest to achieve tax exempt income
*    Shift deductible expenses and income to other taxpayers
*    Defer taxes to the future
*    Offset taxable income with tax losses

With these new tax laws, some review and new approaches will need to be considered for non-grantor trusts and high income taxpayers.

*    For high income taxpayers, the new tax law takes away part of each deduction. Up to 80% of a deduction can thus be eroded. This can make the timing of when to take deductions especially important.
*    Under the new law and with the Obamacare surtaxes, capital gain and ordinary income rates have moved closer together.
*    Delaying paying income taxes on earned income by funneling it into a 401(k) or into IRAs is not the automatic best choice anymore. For some clients, it may be better to recognize income now to achieve future tax-free growth (e.g., by doing a Roth conversion or paying life insurance premiums) since it does not appear that either federal or state income tax rates are likely to come down any time soon. For example, for Californians the top combined income tax rate now exceeds 54% and in New York City the combined total top rate for federal, state and city income tax exceeds 56%.
*    Limited liability companies (LLCs) or other family entity/partnerships can be used to shift income from the founding generation to younger family members who are in lower tax brackets.
*    Medical insurance is 100% deductible at the entity level but can be eroded by the 7.5% or 10% floor and the percentage reduction in deductions at the individual level.
*    Long-term care and disability insurance premiums, too, are 100% deductible at the entity level but subject to up to 80% erosion at the individual level. Plus, entity plans for providing this kind of insurance can be discriminatory.

Adjusted Gross Income (AGI) Is Key
The application of the deduction limitation is determined by the taxpayer’s adjusted gross income (AGI), not taxable income. AGI is the last line on page one of the Form 1040 or 1041 tax return. It includes wages and salaries, capital gains, income from business entities that are reported on Schedule C, and income reported on K-1s and 1099s. The Medicare surtaxes application is determined by a slightly modified AGI (MAGI). AGI and MAGI can be driven up dramatically by a one-time event (such as the sale of a business, investment property or farmland), and can push a client who usually has average income to the highest tax rates and deduction limitations.

Individual Income Tax Rates
The new tax law made permanent individual income tax rates of 10%, 15%, 25%, 28%, 33% and 35% for taxpayers with AGI at or below $450,000 for joint filers and $400,000 for single filers and non-grantor trusts with non-distributed income of less than $11,950. These thresholds are all indexed for inflation after 2013.
*    The 39.6% rate applies above the income threshold amounts.
*    The 3.8% Medicare surtax on investment income and the 0.9% Medicare surtax on earned income have a $250,000 joint/$200,000 single/$11,950 trust or estate MAGI threshold.

Planning Tip: There are different thresholds for head of household and married filing separately taxpayers.

Capital Gain and Dividend Rates
The new tax law made permanent individual capital gain and dividend tax rates of 15% maximum (0% for taxpayers in the 10% and 15% tax rate brackets) for taxpayers with AGI at or below $450,000 for joint filers and $400,000 for single filers.
*    A new 20% rate applies to capital gains and dividends to the extent they plus other taxable income exceeds these AGI threshold amounts.
*    The 3.8% Medicare Surtax applies on the lesser of (a) total investment income and (b) MAGI over $250,000 joint, $200,000 single and $11,950 trusts and estates.

Planning Tip: As with the income tax rates, there are different capital gains and dividend tax thresholds for unmarried head of household and married filing separately taxpayers.

Planning Tip: The increase in the top capital gain and dividend tax rate from 15% to 20% is a 5% increase in the tax rate, but results in a 33% increase in the amount of the tax. Adding in the 3.8% Medicare surtax bumps the combined tax rate to 23.8%. That is an 8.8% increase in the tax rate and a 59% increase in the amount of the tax.

Itemized Deductions Phase Out
At least as significant for high income taxpayers as the rate increases and surtaxes is the itemized deduction phase-out. For taxpayers with AGI over $300,000 joint ($250,000 single), itemized deductions are reduced by 3% of AGI over the threshold level, up to a maximum of 80%total reduction. The phase out applies to deductions other than medical expenses, investment interest expenses, casualty losses (which have severe restrictions) and gambling losses (which can only be offset against gambling income).

NOTE: Mortgage interest and charitable deductions are included in the phase out.

Planning Tip: As with the income, capital gains, and dividend tax rates, there are different phase-out thresholds for unmarried head of household and married filing separately taxpayers.

Planning Tip: The timing of the deduction now becomes more important for the high income taxpayer. A client may want to delay a substantial charitable gift to a year in which his AGI is lower in order to fully utilize the deduction.

Planning Tip: The itemized deduction phase out makes the direct IRA to charity transfer doubly important to eligible (i.e., over 70.5) high income taxpayers. Amounts so transferred do not increase AGI and are not subject to the itemized deduction phase-out.

Medical Expense Deduction Floor Increase
This is a change that affects all taxpayers who itemize deductions. The floor on deductibility of medical expenses has increased from 7.5% of AGI to 10% of AGI for taxpayers under age 65. For the others, the new floor takes effect starting in 2017. Previously, a family with $100,000 AGI would have to have medical expenses of more than $7,500 before being able to take any as an itemized deduction; now they would have to have more than $10,000.

Phase Out of Personal Exemptions
There’s good news and bad news about the personal exemption. The good news is that it is increased for 2013 from $3,800 to $3,900. The bad news is that, similar to the phase out of itemized deductions, personal exemptions are phased out if AGI is over the $300,000 joint ($250,000 single) threshold. The phase-out rate is 2%/$2,500 of above-threshold AGI.

Planning Tip: There are different thresholds and phase-out rates for unmarried head of household and married filing separately taxpayers.

Medicare Surtax on Investment Income
The Obamacare Medicare surtax on net investment income (NII) applies for tax years starting after December 31, 2012. The surtax is 3.8% of the lesser of (a) total NII; and (b) MAGI in excess of $200,000 for single filers, $250,000 for joint filers, $125,000 for married taxpayers filing separately and $11,950 for estates and trusts.

Planning Tip: Previously, investment (also called “passive”) income was taxed at a lower rate than earned or “active” income and could be offset against deductions on real estate. Examples of passive income would include payouts to a participant in an LLC who is not involved in management or to a former business owner who is now in a limited partner role.

Medicare Earned Income Surtax
There has been a lot of publicity about the 3.8% Medicare surtax, but it is not the only Medicare surtax in Obamacare. Obamacare also includes a 0.9% Medicare surtax on wages and self- employment income. This surtax is on the amount by which wages and self-employment income minus MAGI exceeds $200,000 for single filers, $250,000 for joint filers and $125,000 for married taxpayers filing separately. It, too, is effective for tax years starting after December 31, 2012.

Summary of Major Tax Rate and Deduction Changes for Ordinary Income

Planning Tip: Remember that state and local income taxes are in addition to the federal income tax. These taxes, which can exceed 11%, are also subject to the itemized deduction phase out.

Planning Tip: Income tax planning does not focus on the client’s average tax rate, which is the cumulative effect of the various tax brackets and the combined deductions and credits. Tax planners look at the client’s highest marginalrate. Deductions that can be taken and income that can be deferred/offset/eliminated saves at the marginal rate. A lot of people think they are in a lower tax bracket than they actually are and are surprised to learn their marginal tax rate.

Summary of Tax Rates on Investment Income

Income Tax Minimization Strategies for Non-Estate Tax Clients
* Charitable trust planning can create a partially taxable income stream for the philanthropic. Charitable remainder trusts are more attractive now with the higher capital gains tax rates, but some or all of the deduction may be lost due to deduction phase-out for high AGI taxpayers. Non-grantor charitable lead trusts can be more attractive for these taxpayers because the deduction is taken over the term of the charitable distributions rather than at the trust’s inception.

* Annuities remain attractive for the right client in this environment. A 70-year-old client with a 16-year life expectancy can place $1 million into a single premium immediate annuity (SPIA) and receive about $70,000 a year in guaranteed cash flow. A good amount of this annuity’s cash flow income is tax-free because it is a return of the client’s own capital. For the rest, the income tax on the growth inside the annuity is deferred to the year in which the distribution is received, which can be after the client’s retirement. An annuity can be coupled with a life insurance contract held in an irrevocable life insurance trust to provide for the family in the event the client becomes incapacitated or does not live long enough to collect the full annuity payments.

* The Alaska Community Property Trust provides a way for married taxpayers resident in any of the non-community-property states to get the double stepped-up basis on the first death that was formerly available only to residents of the 9 community property states. An Alaska community property trust can save a married couple a considerable amount in capital gain taxes. The right type of client for an Alaska community property trust has assets with high value and low basis and is in a long-term stable marriage.

* Family income shifting through family entities. This was mentioned earlier in the classic strategies. If the client has enough money to live on, he can hire a family member to manage the assets in a family entity and shift income to someone in a lower tax bracket.

* Installment sales of real estate and business assets or entities. Instead of taking a lump sum payout and increasing AGI greatly for one year, taking the payout over time will help to keep AGI at more reasonable levels.

* Tax-free cash value and guaranteed growth of life insurance held in an accessible grantor retirement trust. Because growth in a life insurance policy is tax free if the policy is held to maturity and policy cash value growth is subject to a guarantee, life insurance is more and more often thought of as an asset class.

* Remove or reduce IRA and 401(k) assets from owner and beneficiary income taxes. Eventually someone will have to pay the taxes on these tax-deferred assets, and the beneficiary may be in a higher tax bracket than the owner. Also, often the smallest tax to pay is the soonest tax to pay and instead of continuing to put money in, some clients may be better off to pay the taxes now and take money out or, better still, convert the account to a Roth.

Planning Tip: Use IRA annuitization combined with an ILIT. The client can buy a single premium annuity within an IRA (it’s part of the investment, not a distribution). The annuity then provides a guaranteed cash flow stream that can be distributed and used to make gifts to an ILIT to pay life insurance policy premiums. This can result in paying the least amount of income taxes and providing a greater benefit, especially in the case of the premature death of the insured.

Planning Tip: Use a retirement trust for maximum IRA stretch out over the beneficiary’s lifetime to save income taxes. Ideal is a beneficiary with the least amount of income (lowest tax rate) and longest life expectancy.

* Potential IRA/401(k) Roth conversions. Start timing these conversions to start sooner rather than later. Remember, it is better to pay a little tax now to avoid a larger tax later.

* Intra-family loans and sales. Money can be loaned or property sold for an installment note with 3 – 9 year rates as low as 1% in May 2013 (1.2% Section 7520 rate). This makes now an ideal time for intra-family loans and sales.

Planning Tip: Loans can go the other direction as well. A child with substantial income can loan money to a parent at the applicable federal rate instead of investing it, thereby lowering the child’s income tax rate.

Business Tax Extensions (Opportunities)
For clients who changed from a C Corporation to an S Corporation between 2003 and 2009 and have gain in real estate assets that are trapped in the C Corporation, 2013 is a great year in which to sell those assets. That is because for 2013 the S Corporation recognition holding period is reduced from 10 to 5 years. Carryforward and installment sale rules are also clarified.

Also, there is a 100% exclusion for capital gain from sale of qualified small business stock extended for stock acquired before January 1, 2014, if the stock was owned longer than five years. (The AMT preference rules also do not apply.)

Endangered Strategies
President Obama’s 2014 budget proposal released in April mentions several estate planning tax strategies, which puts them on the endangered list. While no action has been taken on the budget or any of the strategies yet, the fact that the President included them in his 2014 budget proposal gives us some insight into possible future estate tax changes.

*    Grantor trusts still avoid estate tax, including intentionally defective grantor trusts (IDGTs) and irrevocable life insurance trusts (ILITs).
*    Discounts are still allowed on non-business interests or for transfers to minority interests.
*    The ten-year minimum term for grantor retained annuity trusts (GRATs) was not enacted. Two-year rolling GRATs remain available.
*    No 90-year limit on the GST tax exemption was adopted. Dynasty trusts are still possible.
*    Proposed $3.4 million limitation on 401(k)s and retirement plans.

Conclusion
With the enactment of the new Tax Act, income taxes have taken a sharp hike, deductions are being reduced, and everything hinges on adjusted gross income. The advisor who understands this is in a unique position to help clients reduce AGI and save taxes, and will be an invaluable member of the advisory team.

The Internal Revenue Code (“IRC”) provides substantial income and estate tax benefits to the married residents of the nine “community property” states. A tenth state – Alaska – allows married couples to opt in to the community property regime and reap these benefits. In addition, Alaska offers the married residents of the other 40 states a way to reap these benefits by using its community property law.

This simple income and capital gains tax planning trust strategy is one that advisor teams in those 40 states can use to distinguish themselves from other advisors and bring real value to their clients.[1] While this strategy has been underutilized in the 15 years since the Alaska Community Property Act was passed, the recent changes in income and capital gains tax rates have made it especially valuable.

In this edition of The Wealth Counselor, we will review the 2013 changes to the federal income and capital gains tax laws, explain community property law basics and tax benefits, explain how an Alaska Community Property Trust works, and identify some appropriate applications.

The Problem of Capital Gains Tax
Clients hate to pay capital gains tax to the point that they sometimes put themselves at risk to avoid this tax. Portfolios become unbalanced or over-weighted in one or two stocks because clients refuse to sell. Elderly clients are tired of managing rental real estate but won’t sell the property because of the capital gains tax.

Current Capital Gains Tax Rates
Under the Taxpayer Relief Act of 2013 and the Patient Protection and Affordable Care Act of 2010, the capital gains problem is much worse in 2013 for high income taxpayers. Here are the 2012 and 2013 capital gains tax rates for married couples filing jointly:

Adjusted Gross Income                            2012 Rate        2013 Rate
$250,000 to $450,000                               15%                 18.8%
Over $450,000                                          15%                 23.8%

Add State Capital Gains Tax
Several states now have their own capital gains tax. For example, Iowa’s is 8.98%; Hawaii’s is 11%; New Jersey’s is 8.97%. Alaska does not currently have a state capital gains tax.

Add Recapture of Depreciation
For depreciated property, a 25% tax rate will apply to recaptured depreciation. The 3.8% Medicare surtax will also apply to recaptured depreciation if the couple has adjusted gross income of more than $250,000.

Example: John and his wife Mary own an apartment building in Illinois that they purchased for $1 million in 1978. It is now worth $10 million. If they sell it, they will have a gain of $9 million. The property has a depreciated basis of zero, so they will also have $1 million of depreciation recapture. They have more than $450,000 in other income. Here’s what will happen if they sell their apartment building and why they may not want to:

20% Federal capital gains tax (on $9 million)       $1,800,000
25% Depreciation recapture tax (on $1 million)         250,000
3.8% Medicare surtax (on $10 million)                     380,000
5% Illinois capital gains tax (on $10 million)             500,000
Total Tax                                                          $2,930,000

The Hold Until Death Strategy
IRC Section 1014 provides that the basis of property acquired from a decedent that is included in the decedent’s estate for estate tax purposes is its fair market value at 1) the date of the decedent’s death or 2) optionally in a few cases, six months after the date of the decedent’s death. Generally, this results in a “step up” in basis as most property appreciates in value over time due to the effect of inflation. (A “step down” in basis occurs if the market value goes down instead of up between acquisition and death.)

Planning Tip: Many people are tempted to hold onto appreciated property until they die so their children will get the step up in basis.

Example Variation #1: Assume that John is the sole owner of the apartment building and leaves it to Mary upon his death in 2013. Under IRC Section 1014, Mary receives a “step up” in basis to $10 million, the fair market value of the property. If Mary then sells, there is no tax on the gain or depreciation recapture – a tax savings of more than $2.9 million.

Example Variation #2: Assume John and Mary own the building jointly and John dies. IRC Section 1014 provides Mary a “step up” in basis on John’s half of the property to $5 million. Added to Mary’s basis on the other half, that results in a new basis for Mary of $5 million. Upon sale by Mary at $10 million, capital gains tax and recapture is still over $1.4 million.

Community Property
Community property states have marital property laws that were derived from Spanish or French law whereas the “common law” states’ marital property laws were derived from English law. The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. In 1998 Alaska adopted a law that allows a married couple to opt in by written agreement to the community property regime.

Each state’s community property law is slightly different from those of the other community property states, but, in general, a community property regime is similar to a partnership. Each spouse has a one-half undivided interest in the community property, so the property is held as a whole and cannot be divided into his/her shares.

Death Basis Adjustment of Community Property
IRC Section 1014 also provides a special rule for any community property owned by the decedent and the decedent’s spouse. For such property, the IRC Section 1014 basis adjustment applies to both the decedent’s interest in the property and the “property which represents the surviving spouse’s one-half share of community property held by the decedent and the surviving spouse under the community property laws of any state or possession of the United States.”

Here’s how that works:

Example Variation #3: Assume John and Mary own the building as community property. When John dies, the property will receive a full “step up” in basis for Mary to fair market value of $10 million. If she sells it at $10 million, there will be no capital gains tax. Community property treatment thus saves about $1.4 million in capital gains tax. If Mary doesn’t sell, she can depreciate the property’s improvements at its new basis of $10 million minus the value of the land.

Planning Tip: The result is that appreciated real estate, marketable stocks or family businesses held as community property can avoid all capital gains tax upon sale after the death of the first spouse.

The Alaska Community Property Trust 
In our example, John and Mary do not have to move from Illinois to a community property state (and there enter into an agreement converting their marital property into community property) to achieve the result of Example Variation #3. Instead, they can, while remaining Illinois residents, establish an Alaska Community Property Trust and transfer the appreciated property to it while converting it to community property.

An Alaska Community Property Trust thus allows John and Mary to take advantage of Alaska’s community property laws and have their Chicago apartment building characterized as community property.

How It Works
Under the Alaska Community Property Act, Alaska resident married couples may “opt in” to the community property regime, thereby converting some or all of their marital property to community property by written agreement. Under the Alaska Community Property Act, married couples who are not Alaska residents also may “opt in” to Alaska’s community property regime by creating an Alaska Community Property Trust. Such couples may also specify which trust assets they want to become community property.

An Alaska Community Property Trust is a joint revocable living trust. However, the Alaska Community Property Act imposes certain conditions on it. It must have an Alaska trustee, which can be a bank or trust company that exercises trust powers in Alaska or an individual whose true and permanent home is in Alaska. Also, the Alaska trustee must have at least certain specified powers or responsibilities regarding the trust, which do not have to be exclusive. Thus the trustmakers may serve as co-trustees to manage the property and assets held in the trust, and to take the income and, upon the death of the first spouse, have the trust assets “pour over” into the spouses’ home state revocable living trusts.

Planning Tip: Assets transferred to the Alaska Community Property Trust will be titled in a way similar to: “John and Mary Smith, Trustees, and ABC Trust Company, Administrative Trustee, of the John and Mary Smith Alaska Community Property Trust dated ____________.”

Planning Tip: Asset accounts can continue to be managed by the current advisor. An additional statement will need to be provided to the Alaska trustee.

Planning Tip: An Alaska bank or trust company’s annual trustee fee for the minimum services and responsibilities required by the law is likely to be around $2500 per year. Fees are not fixed by law and so a trustee may charge less, especially if the client has another relationship with the bank or trust company. The client can determine if the benefits exceed the costs by comparing the trust creation and maintenance fees over the oldest client’s life expectancy to the amount of capital gains tax that having the trust will avoid.

What to Look for When Evaluating Clients for this Strategy
Clients who are good prospects for establishing an Alaska Community Property Trust are married couples who are not community property state residents and who have one or more of these characteristics:
*    They are in a long-term, stable marriage;
*    They own (or one of them owns) highly appreciated property, stocks, real estate or business interests;
*    Their financial portfolio is over-weighted in one or two stocks that they refuse to sell because of exposure to capital gains tax;
*    They have rental real estate that the likely survivor does not want to manage;
*    They are older or at least one has a reduced life expectancy.

Couples Less Likely to Benefit from Using this Strategy
Clients who are not good prospects for establishing an Alaska Community Property Trust are those with one or more of these characteristics:
*    They have a recent marriage, especially one where property is kept separate;
*    They have an unstable marriage;
*    They have limited low basis property;
*    They are in a second (or subsequent) marriage with prior-marriage children where property is kept separate.

Planning Tip: Advisors in community property states should also be aware of this strategy for their clients who have relocated to a non-community property state.

Alaska Community Property Trusts Benefit Clients and Advisors
Clients
The Alaska Community Property Trust is value-added planning for your clients and is only a part of a more comprehensive plan. It can provide substantial tax savings for the right clients and particularly benefits the surviving spouse more so than the children. It can empower a surviving spouse to diversify their portfolio by removing the capital gains tax exposure. For example, a surviving spouse who has not been involved in the management of rental properties can sell them without paying any capital gains tax.

Advisors
The financial advisor can continue to manage accounts while the property is in the Alaska Community Property Trust and increase capital under management when non-managed property is sold following the death of the first spouse. The advisor who begins to actively promote these trusts has an opportunity to distinguish himself or herself in the community.

Educating the Client and Advisors
The Alaska Community Property Trust is not a well-known strategy and is underutilized by many estate planning lawyers and CPAs. It is often confused with the Alaska Domestic Asset Protection Trust, which is completely different.

Here are some suggestions to help you get started:
*    Identify clients with appreciated property.
*    Calculate their current capital gains tax exposure, including recapture of depreciation.
*    Calculate their capital gains tax exposure if the surviving spouse sells and receives a “step up” in basis on half of the property.
*    Demonstrate the real tax savings potential to clients who would benefit greatly from using the technique.
*    Estimate the costs, including legal and trustee fees, over the life expectancy of the spouse who is expected to die first.
*    Compare those costs to the estimated tax savings at the time of sale (and don’t forget to factor in anticipated asset appreciation to the first death).
*    Team with a WealthCounsel attorney who is familiar with drafting Alaska Community Property Trusts, and who can discuss this strategy with clients and other advisors as needed.

Planning Tip: The Alaska Community Property Trust works well with assets that have been placed in a Limited Liability Company or Family Limited Partnership. (The Alaska Community Property Trust will simply hold a membership interest in the LLC or limited partner interest in the FLP.) It also can work well with buy/sell agreements for family businesses.

Conclusion
The Alaska Community Property Trust offers an exceptional opportunity for the advisory team to collaborate to provide powerful tax savings for their clients. In addition, when an asset is sold without having to pay capital gains tax, the client will have more capital available for additional planning, such as dynasty trusts, and money management for the investment advisor.  Therefore, Alaska Community Property Trusts offer a true win-win for clients and the advisors who recommend this strategy.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax adviser based on the taxpayer’s particular circumstances.