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.

Many clients have large IRAs and retirement plan accounts and need special estate planning for these assets. A 2009 study by the Investment Company Institute found that retirement plans account for 34% of all household financial assets, up from 14% in 1978; IRAs alone account for more than 10% of all household financial assets; and 47 million U.S. households have IRAs.

Compare these numbers to the approximately 4,000 estate tax returns that will be required to be filed annually under the new “permanent” estate tax exemption of $5 million adjusted for inflation, and it is easy to see that planning for retirement accounts presents a more significant opportunity for the estate planning advisory team than does estate tax planning.

Clients want to protect their IRA and retirement plan assets for their families, but most do not understand what can happen to those accounts after they die. And, unfortunately, much of the information plan owners and beneficiaries receive from family members, other lay sources, and, surprisingly, even some advisors is outdated or incorrect.

Without proper planning, trillions of dollars in IRAs and qualified plans that are passed down to clients’ beneficiaries upon death could be exposed to the beneficiaries’ creditors and other beneficiary-associated risks. By using specially designed IRA trusts, the plan owner’s beneficiaries can be protected from creditors, predators, and the temptation inherent in “found” money and thus ensure that the beneficiary achieves the maximum tax deferral that the client intends.

In this issue of The Wealth Counselor, we will explain some of the rules about retirement plans that every member of the advisory team must know and how a properly prepared retirement plan trust (which we will here refer to as an “IRA trust”) can protect the plan assets after the owner’s death.

Problems with Inherited IRAs and Retirement Assets
Impact of Income Taxes
Unless the client’s retirement plan assets are in a Roth IRA or other Roth vehicle, income taxes must be paid whenever assets are withdrawn from these accounts. The top federal income tax rate is now 39.5% and state income taxes, where applicable, are in addition. (The 3.8% Medicare surcharge does not apply to retirement account withdrawals but the withdrawals from non-Roth accounts do get counted in determining if and by how much the taxpayer has exceeded the applicable threshold amount for the surtax.)

Impact of Income Tax Deferral
Different Levels of Protection for IRAs and Inherited IRAs
Qualified retirement plans, including SEP and Simple IRA plans, are protected under ERISA, but traditional, Roth, and inherited IRAs are protected under state laws, which vary greatly. For example, during the original IRA owner’s lifetime, protection can range from unlimited protection to a specified dollar amount or, as in California, to an amount reasonably necessary for the owner and any dependents. Protection for inherited IRAs may be different than that provided to the owner. This varies from state to state and is determined by the beneficiary’s state of residence when the protection question arises. Therefore, only the surest result is obtained through good, proactive planning.

Planning Tip: It is critical to understand how the laws in your state apply to an original owner and to someone who has inherited an IRA. You cannot assume that the beneficiary residing in another, often currently unknown state will have the same asset protection as the owner or a beneficiary residing in your state.

“Found” Money Is Extremely Slippery 
We have all heard of the result of studies of how fast the average beneficiary goes through life insurance proceeds. Spending “found” money simply does not carry the significance of spending one’s own hard earned money. An IRA or other retirement account passing to an individual beneficiary is also “found” money and just as slippery.

IRAs and other retirement plans offer the substantial tax benefit of income tax deferral. Stretching out the inherited retirement plan’s distributions over a beneficiary’s actuarial life expectancy yields a much greater return than if the beneficiary cashes out the plan and pays taxes immediately on the full distribution plus on any future earnings on those assets.

Planning Tip: It can be very helpful to have a chart or calculator that illustrates to clients the benefits of income tax deferral based on his/her actual account balance, actuarial life expectancy, and beneficiaries’ ages.

Divorce and Unintended Beneficiaries
Although an inherited IRA is not a marital asset, it is “on the table” in a divorce because it can be transferred as part of a divorce settlement. Also, the beneficiary of an inherited IRA will make his/her own beneficiary designation in case of death before the account is depleted. Most clients do not want a child’s ex-spouse to get their IRA or a child’s new spouse to inherit because both carry the risk that the client’s grandchildren will be disinherited.

Loss of SSI/Medicaid 
Any inheritance, including assets in an inherited IRA, are considered “resources” for determining SSI/Medicaid eligibility. At least temporary loss of SSI/Medicaid or other government benefits by a disabled beneficiary is hard to avoid if there is more than $2,000 in the inherited IRA.

Planning Tip: Assets held in a properly drafted IRA trust can provide much better protection and ensure maximum stretch out.

Basic Retirement Plan Concepts
A major advantage of qualified retirement plans and IRAs is that the income tax on plan earnings is deferred until withdrawal. With the exception of a Roth IRA or plan account, the account owner (referred to herein as “the owner”) must commence Required Minimum Distributions (RMDs) by his or her Required Beginning Date (RBD). The owner is never required by tax law to make withdrawals from any Roth account but the Roth account beneficiary is.

Required Beginning Date (RBD)
Generally the RBD is April 1 in the year following the calendar year in which the owner reaches age 70 ½ or, for a qualified plan, the calendar year in which the owner retires from employment. There is a qualified plan exception for less than 5% owners. In each year beginning with the year of the RBD, the owner must withdraw at least the Required Minimum Distribution (RMD).

Calculating Required Minimum Distributions (RMDs)
RMDs are calculated by dividing the prior year’s 12/31 account balance by the applicable life expectancy factor as provided by the IRS.

Life Expectancy Factors
There are different life expectancy factors for different account holders. That from the Uniform Table is used for an owner’s lifetime distributions. (This table recalculates life expectancy every year so that even someone age 110 has a life expectancy and will not be required to empty the account.) However, if the owner’s spouse is the owner’s sole beneficiary and is more than ten years younger than the owner, the Joint & Last Survivor Table is used instead of the Uniform Life Table during the owner’s life. The Single Life Table is used by all qualified beneficiaries after the owner’s death.

Planning Tip: When working with a qualified plan, be sure to read the plan agreement and become aware of optional plan provisions. If the custodian is not willing to do what the client wants, consider changing to a new custodian where possible or rolling the account assets into an IRA.

Spousal Rollovers
Only a surviving spouse can rollover an IRA (or qualified plan) into his/her own IRA. Once rolled over, the IRA is treated as if all contributions to it had been made by the surviving spouse. In other words, the surviving spouse uses the Uniform Table to determine RMDs, which must begin by the surviving spouse’s RBD.

Planning Tip: A surviving spouse can defer a rollover indefinitely. If the surviving spouse is younger than 59 ½, rolling over before attaining age 59 ½ risks incurring the 10% early withdrawal penalty. In such cases, consider establishing an inherited IRA and rolling over when the surviving spouse attains age 59 ½. If the surviving spouse is the sole beneficiary, his or her RBD from the inherited IRA is the same as was his or her deceased spouse’s RBD.

Qualified Plan Rollovers by Non-Spouse Beneficiaries
A non-spouse beneficiary is now allowed to do a trustee-to-trustee rollover of a qualified plan to his or her own Inherited IRA.

NOTE: All inherited IRA accounts must be titled in the original owner’s name for the benefit of the beneficiary (e.g., Mary Smith, Deceased, IRA f/b/o Jim Smith). Anything else is considered a 100% taxable distribution.

Designated Beneficiary
If there is a designated beneficiary of the inherited IRA or plan account, the designated beneficiary’s life expectancy is used to determine RMDs in years following the year of the owner’s death. This allows the inherited account to be distributed over the beneficiary’s actual life expectancy, resulting in maximum stretch out and tax deferral.

*    If there is not a designated beneficiary and the owner died before his or her Required Beginning Date, the account must be completely distributed by the December 31 following the fifth anniversary of the owner’s death (the “five-year rule”).
*    If there is not a designated beneficiary and the owner died on or after his or her RBD, the RMD is determined using the Single Life Table as if the owner were still living (the “ghost life expectancy rule”).

A designated beneficiary (as defined by Treas. Reg Section 1.401(a)(9)-4):
*    Must be named a designated beneficiary under the terms of the plan or by an affirmative election by the employee;
*    Need not be specified by name but must be identifiable on the date of death;
*    May be a class of beneficiaries capable of expansion or contraction (e.g., my children or grandchildren);
*    Must be an individual alive on the date of the owner’s death;
*    May be a trust if all of its beneficiaries who have to be considered are individuals alive on the date of the owner’s death, the oldest of whom may be determined (a “qualifying” trust).

A designated beneficiary is NOT:
*    an estate;
*    a charity;
*    a non-qualifying trust;
*    any non-individual other than a qualifying trust; or
*    an individual born after the date of the owner’s death.

The IRA Trust
The advantages of using trusts in general include spendthrift protection, creditor and predator protection, beneficiary divorce protection, special needs planning, consistent investment management, estate planning, and exercising control over the trust assets after the death of the trust maker.

Disadvantages of trusts include greater complexity; legal, accounting and trustee fees; and for trusts that are not required to distribute all their taxable income, greatly compressed income tax brackets (the 39.5% top income tax bracket for individuals begins at $400,000, for such trusts it begins at $11,950).

To be a qualified trust, and thus qualify as a designated beneficiary of an IRA or retirement plan account, an IRA trust must:
1.   Be valid under state law;
2.   Be irrevocable not later than the death of the owner; and
3.   Have beneficiaries all of whom are individuals who are identifiable from the trust instrument when considered on September 1 of the year following the owner’s death.

In addition, the documentation requirement for a trust beneficiary must be satisfied.

Planning Tip: A single revocable living trust would meet requirement #2 because it becomes irrevocable upon the trust maker’s death. However, unless it contains a “conduit” provision, discussed below, a single RLT is unlikely to satisfy requirement #3. A joint revocable living trust would not satisfy requirement #2 because it continues to be revocable until the death of the second spouse. For these and many other reasons, a specialized IRA trust is a preferable IRA beneficiary.

Planning Tip: The documentation requirement is fairly easy to satisfy, but it is vital not to miss the documentation deadline. The trust document must be provided to the account custodian by October 1 of the year following the owner’s death.

Types of IRA Trusts
Conduit Trust
The IRS regulations for IRA trusts provide an example that is commonly referred to as a “conduit” trust. This is a trust in which all distributions from the IRA are required to be immediately distributed to the trust’s beneficiary(ies). With a conduit trust, identification of countable beneficiaries and qualifying the trust as a designated beneficiary is easier because “downstream” and contingent beneficiaries are not considered. On the other hand, because all distributions, including RMDs, must be immediately distributed to the beneficiary(ies), those distributions are not asset protected as they would be if they could stay in the trust.

Accumulation Trust
An accumulation trust is one in which distributions from the inherited IRA may be kept within the trust rather than being distributed to the beneficiary(ies). That way, the trust assets have more protection against creditors and predators. This also more easily allows the beneficiary(ies) SSI/Medicaid eligibility to be preserved. On the other hand, an accumulation trust is a separate taxpayer and is subject to the compressed income tax brackets for undistributed income. Plus, the risk of the trust not being a designated beneficiary (and thus able to take advantage of the stretch) is greater because all beneficiaries have to be considered except those who are “mere potential successor” beneficiaries.

Example: The owner’s child is the primary beneficiary and a charity is the contingent beneficiary. With a conduit trust, the charity would not be counted and the child’s life expectancy would be used to determine the trust’s RMDs, which would produce maximum stretch out and tax deferral opportunity. With an accumulation trust, the charity would be counted and the trust would not be a “designated beneficiary.” That would cause the trust’s RMDs to be determined using the five-year rule or the owner’s ghost life expectancy, depending on whether the owner’s death occurred before or on/after his or her RBD.

In PLR 100537044, the IRS permitted a one-time “toggle” from conduit to accumulation trust. Having such a provision could be important if there is a change in circumstances of a beneficiary (disability, drug problems, etc.) between the time the owner set up the trust and September 1 of the year following the owner’s death. In the “toggle,” any general power of appointment given to a beneficiary must be converted to a limited power of appointment, which can create a Generation-Skipping Transfer Tax issue.

Planning Tip: Consider giving the Trust Protector the “toggle” power in any IRA trust to provide flexibility to deal with possible future events.

Separate IRA Trust vs. Trust in a Revocable Living Trust or Will
A separate IRA Trust is more likely to qualify as a designated beneficiary than is either a non-conduit RLT or trust established under a will.

Commonly encountered issues with using RLTs and trusts in wills as IRA/retirement plan beneficiaries include the possible adverse effects of formula funding clauses; pecuniary clauses and recognition of income; powers of appointment (can expand the class of potential beneficiaries); adoption effect clauses; provisions for payment of debts, taxes and expenses; apportionment language/firewall provisions; older or unidentifiable contingent beneficiary(ies), and non-individual remote contingent beneficiaries.

Drafting Issues and Beneficiary Designations
Revocable vs. Irrevocable
A revocable IRA trust allows for changes to be made easily, but it may open the IRA to the account owner’s creditors at death. See, Commerce Bank v. Bolander, 2007 WL 1041760, Kan. App. 2007. Making the IRA trust irrevocable will protect against the Commerce Bank case problem. Making the IRA trust irrevocable does not have to be a final decision by the IRA owner. While an irrevocable trust may not be changed by its maker, a competent IRA owner can always create a new IRA trust and make a new beneficiary designation pointing to the new IRA trust.

Beneficiary Designations—Separate Shares
If an IRA is payable to an IRA trust rather than the separate beneficiaries’ shares of the trust, the trust’s RMD will be determined by the life expectancy of the oldest trust beneficiary (problematic if one beneficiary is age 60 and another beneficiary is age 2). By contrast, if multiple sub-trusts of an IRA trust are allocated shares of an IRA in the beneficiary designation form, the IRA share of each sub-trust will be paid over the life expectancy of the oldest beneficiary of that sub-trust.

Disclaimer Planning
IRA trusts can contain credit shelter and QTIP trusts for the benefit of the surviving spouse. Proper structuring of the beneficiary designation allows for disclaimer planning for the spouse and other beneficiaries. Note that no further stretch is allowed after the death of the spouse with regard to IRAs not rolled over to the surviving spouse’s own IRA by instead going to a credit shelter or QTIP trust established by the IRA owner.

Planning Tip: The general treatment for disclaimer planning is 1) spouse; 2) if spouse disclaims, IRA trust (for funding of credit shelter/QTIP); 3) if spouse is deceased, to the separate IRA sub-trusts for descendants, per stirpes. Also, children can be given the power to disclaim so that IRA distributions can be stretched out over the owner’s grandchildren’s lifetimes.

Custom-drafted beneficiary designations are required to allow proper disclaimer planning and separate share treatment. (See planning tip above.) However, some IRA custodians will not accept custom beneficiary designations and insist on using their own forms, especially for “smaller” accounts (those under $500,000). In such cases, giving the custodian a choice between losing the account to a more reasonable custodian and accepting the proposed custom beneficiary designation may produce the desired result.

Conclusion
Naming a separate IRA trust as designated IRA or retirement plan beneficiary is preferable to naming beneficiaries outright. It ensures that the client’s goals are carried out, including that the client’s beneficiaries will use the IRA stretch out potential. It provides asset protection against predators, the beneficiaries’ creditors and loss upon divorce. It can provide bloodline protection, preventing unintentional beneficiaries and disinheriting of descendants. It provides for beneficiaries who have or later develop special needs without jeopardizing their valuable government benefits. And it can even keep the IRA assets under the client’s current advisor’s management.

Each client’s situation is different. For IRA trust planning, individual, case-by-case analysis with input from all advisors is essential.

With so much outdated and incorrect information about IRAs and IRA planning being tossed around, current and knowledgeable advisors will stand out and prove invaluable to both clients and the other members of the advisory team.

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.

On January 2, 2013, the President signed into law the American Taxpayer Relief Act of 2012 (the 2012 Tax Act) to deal with the so-called “fiscal cliff.” The 2012 Tax Act included revisions to estate, gift and generation-skipping transfer (“GST”) tax laws and income tax laws that will affect estate planning for the foreseeable future. In this edition of The Wealth Counselor, we will take a first look at those changes and what they will mean to you, your clients and your practice.

Changes to the Federal Estate Tax Law

• The federal gift, estate and GST tax provisions that had been put in place as temporary measures in December 2010 were made permanent as of December 31, 2012. This is great news because, for more than ten years, we have had uncertainty due to the fact that the estate, gift, and GST exemptions and rates, and basic income tax provisions and rates, all had expiration dates. And while “permanent” in Washington only means this is the law until Congress decides to change it, at least we now have some certainty with which to plan.
•  The federal estate and gift tax exemption will remain at $5 million per person, adjusted annually for inflation after January 1, 2011. In 2012, the exemption (with the adjustment) was $5,120,000. The amount for 2013 is $5,250,000. This means that the opportunity to transfer large amounts during lifetime or at death remains.

Planning Tip: If your clients did not take advantage of the $5+ million gift tax exemption in 2011 or 2012, they can do so now—and there are significant advantages to doing so sooner rather than later, as discussed below.

Planning Tip: For clients who used their full $5.12 million exemption in 2012, they have an additional $130,000 exemption they can use in 2013. And, with the exemption amount now tied to inflation, they can expect to be able to transfer even more each year.

• The Generation-Skipping Transfer (GST) tax exemption also remains at the same level as the gift and estate tax exemption ($5 million, adjusted for inflation). The GST tax, which is in addition to the federal estate tax, is imposed on amounts that are transferred (by gift or at your death) and “skip” a generation—for example, a gift to a living child’s descendant.

Planning Tip: Having this permanent GST exemption will allow you to take advantage of planning that will greatly benefit future generations. For example, a dynasty trust that is properly set up can now last forever, and the trust assets should never be subject to federal estate, gift or GST tax.

Planning Tip: The downside of not having trust assets subject to estate tax is that they do not get a basis adjustment to fair market value at death. However, with proper planning, it is possible to elect estate inclusion at the death of a beneficiary to take advantage of the basis adjustment when the beneficiary does not have an otherwise taxable estate.

• Married couples can take advantage of these higher exemptions and, with proper planning, transfer up to $10+ million through lifetime gifting and at death.
• The tax rate on estates larger than the exempt amounts was increased from 35% in 2012 to 40% in 2013 and beyond.
•  The “portability” provision, which allows an executor to transfer the unused exemption of the first spouse to die to the surviving spouse, was also made permanent. While this may at first glance appear to be an easy way to use both spouses’ estate tax exemptions, problems remain. For example, if the surviving spouse remarries and dies before spouse #2, all of spouse #1′s exemption is lost. Also, there is significant cost to using the “portability” provision because it requires filing an estate tax return, and there is no “portability” of any unused GST tax exemption.

Planning Tip: Trust planning remains the best option. It makes excellent use of both spouses’ estate and GST tax exemptions. Trust planning can also provide for a surviving spouse and let the first spouse to die keep control over how his/her share of assets will be managed and distributed. This is important if there are children, and it is critical if there are children from a previous marriage.

• Separate from the new tax law, the amount for annual tax-free gifts has increased from $13,000 in 2012 to $14,000 in 2013 as a result of an inflation adjustment. This means your clients can now give up to $14,000 to as many individuals as they wish each year, and not pay a gift tax. For married clients, the spouse can join and, together, both spouses can give up to $28,000 per person per year.

Planning Tip: Annual tax-free gifts are in addition to the $5+ million gift and estate tax exemption. This is another opportunity for clients to transfer significant amounts out of their estates.

Changes to the Federal Income Tax Law
In addition to these changes to the federal gift, estate and GST tax laws, there are several changes to the federal income tax laws, including several income tax increases that can be mitigated by proper planning:

•  The 2% Social Security tax holiday that was instituted as a stimulus measure was not extended, so everyone will see a decrease in net pay.
• Ordinary income tax rates increase from 35% to 39.6% for singles earning more than $400,000 a year ($450,000 a year for married couples). All other ordinary income tax rates effective in 2012 were made permanent.
• There is a new Medicare 0.9% surtax on ordinary income and a new 3.8% surtax on investment income. Both are applicable to income over $200,000 for singles ($250,000 for married couples) and were part of the 2010 health care bill.
• The top capital gains and dividend rate increased to 20% for those earning more than $400,000 a year ($450,000 for married couples).
• The AMT exemption is now permanent. For 2013, it increased to $50,600 for single and to $78,750 for married taxpayers, with the exemption and phase out amounts indexed for inflation.
• Several business provisions were extended, including the R&D tax credit, work opportunity tax credit, accelerated depreciation, and Section 179 levels.
• The direct IRA to charity transfer for those over 70.5 years of age was reinstituted retroactive to 2012. A special catch-up rule allowed transfers in January 2013 to be counted as 2012 distributions.

The Need for Proper Planning Remains
For most Americans, this tax legislation has removed the emphasis on estate tax planning and put the emphasis back on the real reasons they should do estate planning: taking care of themselves and their families. Proper estate planning is essential to:

• Avoid state inheritance/death taxes that have lower exemptions than federal taxes;
•  Avoid probate, which can be quite expensive and time consuming in some states;
• Ensure assets are distributed the way the client wants;
• Protect an inheritance from irresponsible spending, from a child’s creditors and from being part of a child’s divorce proceedings;
• Provide for a loved one with special needs without losing valuable government benefits;
• See that control of the client’s assets remains in the hands of the person they trust most;
• Provide responsibly for minor children or grandchildren;
• Help protect assets from creditors and frivolous lawsuits (especially important for professionals);
• Protect the client, their family and the client’s assets in the event of your incapacity;
• Establish business succession planning at retirement, incapacity and/or death; or
• Help create meaningful charitable gifts.

For Those with Larger Estates
Ample opportunities remain to transfer large amounts tax-free to future generations. But with the increase in estate and income tax rates, it is critical that professional planning begins as soon as possible.

Planning Tip: Clients do not have to make transfers in cash or liquid assets or completely give away assets. One can transfer illiquid assets like a business, or a home or other real estate, to a trust. If you transfer a home, the owners can continue to live there and take the tax deductions. If a business is transferred, it can be done in such a way that owners can keep control and receive income. By planning now, future appreciation of these assets will not be subject to estate tax, and current depressed values can result in very favorable valuations.

Planning Tip: Clients can leverage their exemption and make it worth much more by using asset value discounts associated with lack of control and lack of liquidity and by using the tax-free growth inside a life insurance policy. Life insurance policy proceeds, when structured properly, can be completely free of probate, and income, gift and estate taxes, and can be protected from beneficiaries’ creditors and predators—even divorce proceedings. Life insurance is also more important than ever because of its income tax benefits, given higher income tax rates.

What to Expect in the Future
With Congress looking for more ways to increase revenue, many reliable estate planning strategies may soon be restricted or eliminated. Already being discussed are minimum terms for grantor retained annuity trusts (GRATs), elimination of valuation discounts for family limited partnerships, limits on installment sales to grantor trusts and other changes to grantor trusts. Other revenue raisers may be proposed that have not yet been widely discussed. Thus, it is beneficial to implement these strategies as soon as possible to increase the likelihood that they will be grandfathered should Congress decide to change the law.

Conclusion
For clients who have been sitting on the sidelines, waiting to see what Congress would do, the wait is over. Now that we have some certainty with “permanent” laws, there is no excuse to postpone planning any longer. In fact, delaying planning could cause your clients to lose out on strategies that could have significant benefit to their families. Encourage your clients to take action today.

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.

“Most people give up just when they’re about to achieve success.” – Ross Perot

Judging by what we have been hearing from new and current clients, Mr. Perot up there in my quote selection (with all due respect for his obvious business acumen) probably never prepared his own taxes.

And I recommend you do not either. We do not prepare them, and have no fiduciary interest in recommending you do so … but, the thing sort of speaks for itself, I would say. How can I say this?

Consider…

The Form 1040 instructions estimate that on average it takes a taxpayer around 18 hours to complete a tax return.

And that is the average. And speaking of average, there have been approximately 4,680 changes to the U.S. tax code (let alone the states) since 2001, which is an average of more than one per day.

And when you print out the *guidance* explaining the tax code, it is over 1-foot high. Let alone the 4 million words of the code itself.

So, let me know if you need a recommendation — but please let’s not have you tackle this yourself. (Remember what that did, even, for our esteemed Treasury Secretary, Tim Geithner!)

With the help of a CPA, I have put together this yearly list of items you should be gathering these next few weeks as you prepare for tax time. It is my hope that this will help you to delegate this sometimes-painful process effectively. I hope it’s helpful!

This list is mostly complete–but I am always looking to add to it! Let me know if you think I missed anything.

Personal Data
Social Security Numbers (including spouse and children)
Child care provider tax I.D. or Social Security Number
Employment & Income Data
W-2 forms for this year
Tax refunds and unemployment compensation: Form 1099-G
Miscellaneous income including rent: Form 1099-MISC
Partnership and trust income
Pensions and annuities
Alimony received
Jury duty pay
Gambling and lottery winnings
Prizes and awards
Scholarships and fellowships
State and local income tax refunds
Unemployment compensation

Homeowner/Renter Data
Residential address(es) for this year
Mortgage interest: Form 1098
Sale of your home or other real estate: Form 1099-S
Second mortgage interest paid
Real estate taxes paid
Rent paid during tax year
Moving expenses

Financial Assets
Interest income statements: Form 1099-INT & 1099-OID
Dividend income statements: Form 1099-DIV
Proceeds from broker transactions: Form 1099-B
Retirement plan distribution: Form 1099-R
Capital gains or losses

Financial Liabilities
Auto loans and leases (account numbers and car value) if vehicle used for business
Student loan interest paid
Early withdrawal penalties on CDs and other fixed time deposits

Automobiles
Personal property tax information
Department of Motor Vehicles fees

Expenses
Gifts to charity (receipts for any single donations of $250 or more)
Unreimbursed expenses related to volunteer work
Unreimbursed expenses related to your job (travel expenses, entertainment, uniforms, union dues, subscriptions)
Investment expenses
Job-hunting expenses
Education expenses (tuition and fees)
Child care expenses
Medical Savings Accounts
Adoption expenses
Alimony paid
Tax return preparation expenses and fees

Self-Employment Data
Estimated tax vouchers for the current year
Self-employment tax
Self-employment SEP plans
Self-employed health insurance
K-1s on all partnerships
Receipts or documentation for business-related expenses
Farm income

Deduction Documents
State and local income taxes
IRA, Keogh and other retirement plan contributions
Medical expenses
Casualty or theft losses
Other miscellaneous deductions

Washington’s negotiations about 2013 tax laws are getting lots of press. As estate planning professionals, we are often asked our opinions about what the 2013 estate tax laws might be and the resulting implications for our clients. But for the vast majority of Americans, what the estate and gift tax laws will be in 2013 is really irrelevant. Those who could make large gifts have probably done so in 2012, and the 2013 estate tax exemption is only relevant to those who have a 2013 death.

Yes, it is important for us to be aware of the state of the tax law. We can keep our ear to the ground for warnings of change emanating from Washington, but nobody has any kind of a handle on what the law will be in 5, 10, 15 or 20 years! What we all need to do is redirect our clients’ inquiries to their real concerns: protecting their families and assets; preserving the family business; making sure their children are provided for, educated and motivated; seeing that their loved ones have enforceable rights where the law may not grant them; and making sure their plans do not self-destruct for lack of proper maintenance. These are the enduring issues that drive estate planning, regardless of what the estate tax law may be at any given time.

In this issue of The Wealth Counselor, we will take another look at one of those client concerns — asset protection. With our increasingly litigious society, asset protection planning has become more important and is often a key motivator for clients who need other estate planning, too.

What is Asset Protection Planning?
Asset protection planning is not hiding or concealing assets. Rather, it is helping clients use existing laws appropriately to obtain the best possible level of protection for their assets against possible attack by creditors. The goal is to make planning decisions that are effective if and when needed because they have legitimate non-asset protection purposes and thus are defensible.

The best and most effective time to implement asset protection planning is before a claim arises, when the client is merely worried that someday there may be claims founded on possible events that have not yet happened. But even after a claim has been made, some opportunities (such as making a contribution to an ERISA qualified plan or doing a Roth conversion) may still be available to shield some assets.

Types of Client and Asset Risks
Almost every client would benefit from some asset protection planning, but like most things in life there is a cost to achieve the benefit. Asset protection planning is advanced planning and requires collaboration from a team of advisors, so sometimes the cost outweighs the benefit. Therefore it is important that each member of the advisory team be able to recognize the types of clients whose profile indicates they might be good prospects for asset protection planning. Here are a few of the main ones:

Professionals
The clients who are the best prospects for asset protection planning are those most likely to be sued. At the top of the list are physicians, surgeons, dentists and other health care professionals. Running a close second are lawyers, architects and accountants. A third category is clients involved with business enterprises that pertain to health care, such as skilled nursing facilities and assisted living facilities. Builders, developers and others in construction are also at risk. Those who have already gone through a lawsuit will be keen to avoid the fear of loss associated with another one.

Planning Tip: A professional is liable for the consequences of his or her own negligence and everyone makes mistakes. Therefore, a professional’s liability protection should begin with adequate malpractice or errors and omissions insurance coverage.

Partners 
In a general partnership, each partner is liable for the negligent acts of every other partner and every employee. It is rare to encounter a general partnership of medical professionals, but much more common with lawyers and architects. Plus, partnerships can come into existence without any paperwork as a business is started and then the clean-up sometimes doesn’t get done as the business grows.

Entrepreneurs and Executives
Attacks on entrepreneurs could come from business deals that have gone bad or tort claims. Management level personnel are exposed to claims for alleged improper employment practices, employment discrimination, or sexual harassment.

Landlords
Clients who own residential rental properties have often acquired them one-by-one over time. Frequently they are owned in the landlord’s name. Every residential property exposes its owner to premises liability claims, such as for injuries from fires and slip-and-fall accidents. Legal structures can be set up that isolate a property from these risks associated with another property and separate the landlord from all the risks.

The Wealthy 
The wealthy are exposed to more risk of lawsuits because they have the ability to pay and juries are often sympathetic to the plaintiff when the defendant is rich. Also, they often have staff, multiple properties and multiple vehicles and those impose claim risks, too.

Lifestyle-Based Candidates
Clients who have had more than one spouse are statistically at higher risk of divorce than those in first marriages. Many a business has collapsed as a result of an ex-spouse claiming an ownership interest in the business.

A client’s child who engages in risky or antisocial behavior creates a risk of future unnecessary dissipation of a family’s wealth; often leaving the child destitute with no one to turn to once the parents are gone.

Levels of Asset Protection
Every asset protection plan is a unique creation designed to meet the particular client’s needs, risks and concerns. Typically, an asset protection plan employs a combination of strategies. Because asset protection planning is a process that frequently takes months to fully implement (and because wisdom dictates building the foundation before starting on the roof) in general asset protection planning should be implemented by levels, starting at the lowest. The lower rungs on the ladder don’t get you very far off the ground, but they are dangerous to skip. Asset protection planning works the same way. A typical planning level strategy that would be presented to a highly compensated professional in a high risk profession would be:

Level 1:           Exemptions
Level 2:           Transmutation or Tenancy by the Entirety Agreements
Level 3:           Professional Entity Formation (PA/PC/PLLC)
Level 4:           FLP/FLLC to Own and Lease Practice Assets
Level 5:           FLP/FLLC to Own Non-Practice Assets
Level 6:           Domestic (U.S.-Based) Asset Protection Trusts
Level 7:           Offshore Asset Protection Trusts

Below we discuss each of these seven levels.

Planning Tip: The plan presented should include levels above those that the client will probably choose. This gives the client appropriate control and decision making responsibility and also avoids the risk of the client legitimately complaining that particular strategies were not offered.

Level 1: Exemptions
Some assets are automatically protected by state or federal exemptions. State exemptions can include personal property, life insurance, annuities, IRAs, homestead, and property held in tenancy by the entirety. Each state protects its citizens’ assets differently and the amounts of the exemptions will also vary greatly from state to state. For example, some states have an unlimited homestead exemption; many states protect all IRAs; and many non-community property states recognize tenancy by the entirety, which is sometimes a great way to shelter the interests of both the spouse who is at risk and the spouse who is not.

Federal exemptions include ERISA which covers 401(k) and 403(b) plan accounts, pensions, and profit-sharing plans. Creating and funding qualified retirement plans for clients can provide excellent shelters against creditors’ claims. Typically these plans must also include one or more non-owner employee participants in order to be covered by ERISA. Skillful pension actuaries can be very helpful with this.

While the federal Pension Protection Act protects up to $1 million in IRAs and Roth IRAs for bankruptcy purposes, the level of non-bankruptcy protection afforded by the states to their citizens’ IRAs varies widely.

For a client who lives in a state with weak IRA protection, it might be best to move unprotected IRA assets into an ERISA qualified retirement plan which is unreachable by third-party creditors during the pay-in period (some portion of required minimum distributions may be reachable by creditors). For the client who lives in a state with strong IRA protection or who has not used all of the IRA protection available in their state, converting a traditional or roll-over IRA into a Roth IRA and paying the taxes with non-IRA funds can be an excellent asset protection strategy that is easily and quickly implemented.

Planning Tip: With today’s low interest rates, defined benefit plans are becoming popular again. Instead of the required annual fixed contributions of the past, the IRS now allows almost as much flexibility with defined benefit plan contributions as it does with profit-sharing plans. Contributions can also be increased dramatically to allow for the use of life insurance within the plan. Life insurance can be an especially valuable asset because death benefits are not subject to income or capital gain tax, and if the policy ownership and control is done right, the death benefit is not part of the insured’s taxable estate.

Planning Tip: Sometimes it is possible to convert non-exempt assets into exempt assets. For example, cash (a non-exempt asset) can be used to pay down a homestead mortgage and increase exempt home equity. This is a strategy for clients who live in states with a large or unlimited homestead exemption.

Planning Tip: Because home mortgages and home equity lines of credit are currently hard to get, a qualified personal residence trust (QPRT), established as an ongoing trust to benefit younger family members, can also be used. However, because it is a self-settled irrevocable trust, some states have limitations that can reduce a QPRT’s effectiveness for asset protection. Also, putting an unprotected home asset into a QPRT when there is a known or anticipated claim could be held to be a fraudulent transfer.

Planning Tip: The exemption level asset protection strategies may even be available to the client who has already been sued.

Level 2: Transmutation or Tenancy by the Entirety Agreements 
There are asset protection strategies for married clients that depend on how title is held to an asset. In most of the states, the available technique is converting jointly held property to tenancy by the entirety property. In the nine community property states, the technique of choice is the agreement to transmute community property into separate property. Both techniques have legal consequences beyond asset protection that must be explained to, understood and accepted by the client.

Converting jointly held property into tenancy by the entirety can make it inaccessible to an at-risk spouse’s creditors while the other spouse is living. Transmutation agreements allow clients to convert community property assets into the separate property of the spouse not at risk. Make sure the client is aware that property once transmuted stays separate property unless and until another transmutation agreement converts it back to community property. Separate counsel for each spouse may be needed to make a transmutation agreement binding. Plus, there may be enhanced risk of loss of property in case of a divorce.

Level 3: Professional Entity Formation (PA/PC/PLLC)
General partnerships and sole proprietorships under which a professional is conducting business should be restructured as a professional association or corporation (which depends on state law) or a professional limited liability company. By so doing, each professional will become protected from personal liability for the errors of other professionals and employees. Putting that protection in place is a good second step beyond having adequate malpractice insurance.

State laws will vary on this. If available, a PLLC is usually more desirable because of the charging order limitations that prevent a professional’s creditor from seizing any assets from the entity, limiting the creditor to only receiving distributions that would have been made to the affected debtor-member. In addition, the creditor may have to pay tax on any income that is distributed under a charging order. This is often enough to discourage a creditor from pursuing a claim or to make settlement on a favorable basis possible. Establishing the entity under the laws of a state that has the charging order as the sole creditor remedy, when that is possible, should also be considered.

Level 4: LP/LLC to Own and Lease Practice Assets
An LP or LLC can be created to own the specialized or valuable equipment and/or real estate that is used in the professional practice. “Lease back” agreements can then be created between the professional practice and the property owning LLCs. This strategy allows the professional to isolate valuable real estate and equipment from malpractice exposure. In some cases, a factoring arrangement can put the value of the practice’s accounts receivable in the LP or LLC and thus beyond the reach of a malpractice creditor.

Planning Tip: Creating an LP or LLC to own practice assets also allows for good estate planning by providing the opportunity for gifting or sale of LLC/LP interests to irrevocable trusts established for the benefit of children or other family members.

Level 5: FLP/FLLC to Own Non-Practice Assets
Consider the formation of a family limited partnership or family LLC in a favorable jurisdiction that has the charging order as the sole remedy to own non-practice assets. This entity would hold personal use real estate, investment accounts, cash or bank accounts, and investment real estate. Having a multi-member LLC increases the charging order protection because a bankruptcy judge cannot collapse a multi-member LLC that was formed in a favorable jurisdiction.

Level 6: Domestic (U.S.-Based) Asset Protection Trusts
Historically, creditors were able to reach assets that their debtor had placed into an irrevocable trust for the debtor’s benefit. Such trusts are called “self-settled.” Starting with Alaska in 1987, several states have adopted laws that allow the assets of certain self-settled trusts to be protected from the grantor/beneficiary’s creditors. These trusts are called asset protection trusts. Because they are formed under a state’s jurisdiction as opposed to the jurisdiction of another country (see Level 7, below) this kind of trust is commonly referred to as a Domestic Asset Protection Trust (DAPT).

The time between creating the DAPT or placing an asset in the DAPT and the DAPT affording protection to that or all DAPT assets varies from state to state, with the shortest time being two years.  In like manner, the states have different lists of creditor or claim classes to which the DAPT’s asset protection does not apply. The most popular states for DAPT formation are, in alphabetical order, Alaska, Delaware, Nevada and Wyoming.

In Level 6 planning, the client establishes a DAPT in the selected jurisdiction and funds it with non-practice, non-leasing LLC assets.

Each DAPT state has its own rules that will need to be satisfied for a DAPT established under its laws to be effective. For example, the state’s DAPT law may require that a trustee have an office in that state or that some of the trust assets be held there. Associating local counsel in the chosen DAPT jurisdiction may be appropriate.

Planning Tip: Because clients today are often living into their 90s, it is wise to build flexibility into a DAPT or other irrevocable trust to accommodate changes in a client’s needs and family over several decades. To do this, the trust can be made changeable by an independent third party of the client’s choosing. This role is commonly referred to as the “Trust Protector.”

Planning Tip: A trust can be designed so that transfers to it are, for gift and estate tax purposes, completed or incomplete gifts. Incomplete gifts are included in the grantor’s estate for estate tax purposes and get a basis adjustment at death. The opposite is true for completed gifts that are not brought back into the grantor’s estate under what are called the “string” sections of the Internal Revenue Code (26 USC §§ 2035-38 and 2042). Be sure to determine what is best in each case.

Level 7: Offshore Asset Protection Trusts
The highest (and most expensive to establish and maintain) level of asset protection planning is founded on one or more asset protection trusts established under the laws of a foreign jurisdiction. (The Cook Islands, the Bahamas, Bermuda and the Channel Islands are all popular choices.) With an offshore trust, the assets are in the hands of a local trustee and are outside the reach of any U.S. court. However, there may be tax issues. Also, if the court orders the assets repatriated and they can’t be, the client could be cited for contempt and even jailed.

Planning Tip: An offshore asset protection trust should not hold assets in the United States over which a U.S. court could exert jurisdiction.

Implementing the Asset Protection Plan
The advisors independently and collectively will make a list of the client’s assets and determine what needs to be done with each one to implement the levels of planning selected by the client. It can easily take six months to a year to design, implement and fully fund a comprehensive asset protection plan, and it’s usually done in steps and pieces. During the process, it’s very important to keep the client informed and keep everyone on a timeline.

Protecting the Advisor Team
Asset protection planning can pose a risk to the advisor team members’ assets. Those risks need to be avoided. One risk is the client who, when his or her assets are under attack, will forget that no advisor guaranteed the plan’s success. The other risk is that the client’s creditors, who just want money and don’t care who pays, may try to bring the asset protection planning team members into the fray under “fraudulent transfer” allegations.

Tempering Expectations and Documenting the Agreement
To deal with the first risk, it is important to set some reasonable expectations for the client and for the client to be educated about what asset protection is, how the laws work, and what the client can reasonably expect to achieve. For example:
*    Most people would like to have a high degree of certainty of the outcome. The advisors have to temper that expectation by explaining how the law works and that there may be circumstances that nobody can effectively control. Asset protection is time consuming, but worthwhile. The end result should be considerably better than if the client had done no planning at all.
*    Many clients want to maintain control rather than shift assets to some unknown third party in a foreign land. The preferred approach is to maintain control or at least oversight over the assets.
*    An effective plan will discourage lawsuits from the outset. We cannot make our client’s assets appear not to exist, but we can create a structure that will make it less attractive for a potential plaintiff to go after our client than to go after someone who has done no planning. And we can enhance our client’s ability to negotiate a favorable settlement if liability is established.

We very highly recommend that a detailed written asset protection engagement agreement be signed in all cases. The agreement should spell out the plan goals, limitations and potential risks and negate the idea of there being any guarantee of success.

Avoiding Fraudulent Transfer Exposure
The natural tendency of the debtor is to hide assets to frustrate the creditor who would seize them. To deal with that problem, there are “fraudulent transfer” laws. Each state has one and there is one in the Bankruptcy Code. In general they allow a creditor to unwind certain transactions in which the debtor has transferred assets to another for anything short of full and fair consideration with the intent of hindering or defrauding creditors. These laws also impose personal liability on anyone who aids or abets the debtor in these activities. Therefore, the advisor team members all want to make sure that they have a good defense to any frustrated creditor’s claim that they took any action that was reasonably calculated to aid their client in implementing a fraudulent transfer.

The key to the advisor team members avoiding exposure to a claim of abetting fraudulent transfer is to make sure to gather financial and objective information and to build a relationship with the client before designing or implementing the asset protection planning. Once the facts are known, no matter how bad they are, some level of asset protection planning can probably be done. Without knowledge of the facts, the asset protection plan designed by the advisors is likely to fail.

Planning Tip: Because the natural tendency of many is to procrastinate, often the client who seeks asset protection planning already has a claim pending or impending against them.

Planning Tip: Because asset protection planning is most attractive to those who have a higher than average risk of being sued, it is critically important to determine early in the planning process how much information the client is willing to share and should share with various members of the advisor team. For example, it may be vital to preserve attorney/client privilege about some things and therefore not share specific risk information with non-attorney advisors who could be subpoenaed. Short of being sued, there is not much worse for an advisor than to be called to testify against a client!

Planning Tip: Clients may misrepresent their legal difficulties, and none of us wants to subsidize a plaintiff’s claim through the use of our own malpractice insurance because of not asking the right questions or doing a thorough discovery. An excellent practice is to have in your file a solvency certificate from your client in which the client represents to you in writing that their net worth is a positive number and that the planning they are going to do will not render them insolvent. In some instances it is useful to obtain permission from the client in order to do due diligence and independently investigate to make sure you know the information provided is accurate.

Conclusion
Asset protection planning is just one client concern that can be the impetus that gets the client to do estate planning. While it is highly important that the advisor team members know and understand the current estate tax laws, nobody knows what those laws will be in the future when the client’s planning “matures.” Other than in very rare cases, the current tax laws themselves are irrelevant to, and are rarely the motivating factor for, our clients’ planning. What our clients want and need is predictability coupled with flexibility. Members of the advisory team who are aware of the enduring concerns clients have will find many opportunities to work together for the benefit of the team members and their clients.

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.

Year-end tax planning is always important, but this year it is especially difficult because of uncertainty about what the tax laws will be for 2013. The Bush-era tax cuts are scheduled to expire on December 31 and the President and Congress have once again delayed taking any action. No one knows which, if any, of the Bush era tax cuts will be extended or which, if any, will be allowed to lapse, in whole or in part. Almost everyone, however, is expecting that taxes will increase because of the large deficit between the federal government’s spending and its revenue.

While we wait to see what the President and Congress agree on, right now our clients have some exceptional planning opportunities that may soon be gone. We can help them plan with the 2012 opportunities we have, and we can create plans flexible enough to adapt to whatever the President and Congress do. In addition, there are new taxes that we know will apply January 1 that must be planned for. All members of the advisory team need to stay informed and alert to changes in order to help clients at this critical time.

In this issue of The Wealth Counselor, we will discuss possible and known changes in the tax laws for 2013, strategies for income and estate tax planning, and some planning opportunities that should be taken advantage of now, before they disappear.

Expiration of Bush-Era Tax Cuts Will Mean Higher Taxes for Everyone
If the President and Congress do not act before the end of the year, the Bush-era income tax cuts will expire along with the December 2010 transfer tax increases (estate, gift, and generation-skipping transfer [GST] taxes) and those tax laws will revert to what they were in 2001. If that happens:

• The 10% income tax bracket will be eliminated and the rates in the current 25% and higher income tax bracket will all increase.
• The marginal income tax rate for top earners will increase from 35% to 39.6% plus a Medicare surtax (discussed below).
• The long-term capital gains tax rate will increase from 15% to 20%.
• Dividends will be taxed as ordinary income instead of at 15%. For top earners, this means dividends will be taxed at 39.6% plus a Medicare surtax.
• Lower income bracket taxpayers (those now in the 10% and 15% brackets) will no longer be exempt from paying tax on capital gains and dividends.
• The estate tax exemption will go from $5.12 million to $1 million. Assets over the exempt amount, currently taxed at 35%, will be taxed at graduated rates starting at 35% and going up to 55%. This means more assets will be taxed at higher rates.
• The same thing will happen to the gift tax exemption.
• The generation-skipping transfer tax exemption will go from $5.12 million to $1 million, adjusted for inflation, and the rate will increase from 35% to 55%.
• Many other tax provisions will also become less generous.

New Tax Rules for 2013
We already know that these new tax rules will go into effect on January 1, 2013:

• A 0.9% Medicare surtax on a taxpayer’s wages over $200,000 if single, $250,000 for joint filers. Withholding begins when earnings exceed $200,000 regardless of marital status. This additional tax also applies to net earnings from self-employment. This additional tax is not imposed on the employer.
• A 3.8% Medicare surtax on net investment income for singles with MAGI (modified adjusted gross income) over $200,000, $250,000 for joint filers; $11,950 for estates and trusts. This tax applies to the lower of total net investment income for the year or MAGI over the applicable threshold.

Planning Tip: Be sure to determine what is part of net investment income and what is excluded. Also, note the lower threshold of just $11,950 for estates and trusts; careful selection of year-end for estates and trusts can allow for up to 11 more months free from this tax.

• Itemized medical expenses will be deductible only to the extent they exceed 10% of AGI. Those age 65 and older can continue to use the 7.5% AGI floor through 2016. The 10% floor continues to apply for AMT purposes.
• Flexible Spending Account salary reduction contributions are capped at $2,500.

Estimated COLAs for 2013

• Tax brackets would increase by about 2.5%. Note: There will be a 10% bracket only if Bush-era cuts are extended.
• Personal exemption would increase from $3,800 to $3,900. A phase-out of personal exemptions would again apply if Bush-era cuts are not extended. (There has been no phase-out since 2010.)
• Standard deductions are expected to increase:
• Singles: $6,100 (up from $5,950)
• Heads of household: $8,950 (up from $8,700)
• Joint filers: $12,200 (up from $11,900)
• Dependents: $1,000 or earned income plus $350 (up from $950 or earned income plus $300)
•  Additional amounts for age and/or blindness: $1,500 for unmarried (up from $1,450); $1,200 for married filers (up from $1,150)
• Long-term care insurance taken into account for the itemized medical deduction rises to $360 for those under age 40 and to $4,550 for those over age 70 (up from $350 and $4,370, respectively).
• Per diem exclusion for long-term care insurance proceeds will be $320 (up from $310)
• Itemized deduction phase-out will apply unless the Bush-era tax cuts are extended.
• Adoption credit will be $12,770 (up from $12,650) if Bush-era tax cuts are extended. If not extended, the credit falls to $5,000 ($6,000 for a special needs child).
• Exclusion of interest on U.S. savings bonds redeemed for higher education; MAGI threshold increased.
• Foreign earned income exclusion will be $97,600 (up from $95,100).
• IRAs and Roth IRAs contribution limit increased to $5,500 (up from $5,000 first set in 2009); those age 50 or older by year end can add another $1,000. MAGI limit on making Roth IRA contributions increased. MAGI limit on making deductible IRA contribution by active participants increased.
• Annual gift tax exclusion will be $14,000 per donee (up from $13,000); joint gifts by married couples up to $28,000 per donee.
• Lump-sum contribution to 529 plan will be up to $70,000 using the five-year gift tax rule (up from $65,000).
• U.S. person receiving foreign gifts must file a gift tax return for gifts exceeding $15,102.
• Planning Strategies for Income Taxes

Here are some strategies for December 2012:

Assess the client’s current tax picture. Review capital gains and losses already realized for 2012 (including carryovers). Check mutual fund payouts for 2012 (usually available from fund managers by November). Determine whether there will likely be a year-end bonus.

Take action for capital gain and loss planning. Actualize gains and losses on securities in taxable accounts as desired to the extent possible within the accounts. Sell investment real estate this year. Determine whether and how much of ISOs to exercise before the end of the year, being sure to consider AMT. Watch the wash sale rule when harvesting losses.

Planning Tip: Clients will probably want to sell assets in 2012 if they will need the proceeds over the next several years. A $100,000 long-term gain in 2012 will generate $15,000 in taxes; but the same gain in 2013 will generate about $25,000 in taxes as a consequence of scaled-back itemized deductions, the 3.8% surtax and a higher capital gains rate.

Planning Tip: Pull interest income into 2012 and push interest expense into 2013 where possible. For wealthiest clients, their income tax rate will increase from 35% to 43.4%, barring action in Washington.

Take action for dividends. Watch the holding period to nail down the capital gain rate on qualified dividends. Take into account reinvested dividends in figuring the basis of stock/mutual fund shares sold in 2012. Sale of a stock in December that will pay a dividend in January or February could be a good strategy.

Planning Tip: The “wash sale” rule does not apply to gain harvesting, so a stock sold realizing a gain can be added back to the client’s portfolio immediately.

Take action for retirement accounts. Consider converting IRAs to Roth IRAs. All resulting income must be reported in the conversion. (Remember to factor in the 50% conversion income from conversions made in 2010.) Remind clients to take their 2012 Required Minimum Distributions. Assess whether to roll over qualified plan distributions or pay tax on them in 2012.

Planning Tip: Watch for the possible retroactive extension of the ability to make the $100,000 direct transfer from IRA to charity for those age 70 1/2 and older.

Take action for deductible expenses. Pull some deductions into 2012 and push some into 2013. Consider incurring unreimbursed medical costs (such as Lasik eye surgery and dental implants) before year end in light of the increased floor for itemizing medical expenses (7.5% goes to 10%). Consider a Health Savings Account; a full-year contribution for 2012 can be made as long as there is coverage under a high-deductible health plan for December and coverage continues for a set period. For other deductions, offsetting 2013 income may result in larger savings if the Bush era tax cuts applicable to them expire.

Planning Tip: Make charitable deductions now; the phase-out on high-income taxpayers may apply in 2013 unless Congress keeps the status quo.

Planning Tip: Don’t prepay state and local income taxes or property taxes if subject to the AMT. (If Congress has not enacted a “patch” by the end of the year, use the 2011 exemption amounts to make projections.)

Take action for other income strategies. Determine whether to accelerate or defer compensation, including year-end bonuses, if this is an option. Adjust the fourth estimated tax payment to reflect year-end actions.

Take action for year-end strategies for businesses. Cash basis businesses should re-assess the standard strategy of deferring income and accelerating deductions. Purchase machinery and equipment before the end of 2012. (Section 179 deduction is set to decline in 2013 to $25,000 and the 50% bonus depreciation to end.) Review the business structure in light of business considerations as well as the additional Medicare taxes.

For C corporations, determine whether to pay dividends in 2012 if no deal is struck in Washington that will extend the favorable treatment of dividends; watch for excess accumulations; authorize charitable contributions before year end (C corporations can deduct them if paid within the first 2 1/2 months of 2013); review final estimated tax payment (if losses are expected for the year, adjust the final estimated tax payment and prepare to file a quick refund).

Strategies for Estate Planning
It is impossible to predict what will happen with transfer taxes and estate planning, but the climate in Washington is certainly different than it was in 2010 when the Bush tax cuts were extended for two years and the transfer tax exemptions were greatly increased during the extension period. Planners can, and really must, encourage their clients to use the planning tools that currently do exist as they are likely to change adversely in the near future.

Use the $5.12 transfer tax exemptions now. Estate tax and gift tax and GST tax exemptions are all currently linked at this historic level. However, most believe that even if the estate tax exemption stays higher (say, $3.5 million), the gift tax exemption will likely go down, perhaps all the way to $1 million. For many older clients with net estates between $1 million and $5 million, using the unified credits now can be excellent planning, especially if the exemptions are lowered in the next few years.

Planning Tip: High basis assets can be put in a trust for the spouse now and for the children and/or grandchildren later. With low basis property, a switch to turn on a general power of appointment can be included in the trust so that if the surviving spouse has unified credit remaining at her death, the trustee can bring the lowest basis assets into the surviving spouse’s estate.

Use the $5.12 million generation skipping transfer tax (GSTT) exemption now. This can provide significant savings in estate taxes over the generations. Under current law, several states have laws that permit creating trusts that can last forever.

Pay some gift tax now. The current gift/estate tax rate is 35%. If it increases to a top bracket of 55% in 2013, making gifts in 2012 can potentially save 20% on the tax rate for those who will have large taxable estates. Another benefit is the tax-inclusive nature of the estate tax whereas the gift tax is paid only on the amount of the gift.

Make gifts of family entities. For years, the IRS has been talking about getting the government to take away discounts on family entities. It would be smart planning to use this while we still have it.

Make gifts to dynasty trusts. President Obama has proposed a 90-year federal rule against perpetuities, which would take away the opportunity to create long lasting dynasty trusts. For very wealthy clients, these are critical to multi-generation wealth preservation and transfer.

Create spousal access trusts. A husband can create a trust now and his wife can have access to the trust assets until her death. A wife can also do this for her husband. However, these trusts must be created very carefully to make sure there are enough differences in them to avoid application of the “reciprocal trust” doctrine.

Use GRATS and Charitable Lead Trusts. Current low interest rates make these very attractive. President Obama has proposed limiting the minimum GRAT term to 10 years, eliminating the zeroed-out GRAT option, including grantor trust assets in taxable estates and gifts, and imposing a tax on trust distributions. Again, it would be smart to use these tools while we still have them.

Planning Tip: Be careful with gift splitting; it is not permitted if the non-donor spouse is going to be a beneficiary of the trust.

Planning Tip: Be sure to address the GST exemptions correctly when doing gift tax returns. Annual exclusion rules for the GST tax are different from those for the gift tax. Plus, automatic allocation rules are one of the Bush era provisions that are scheduled to end on December 31 and thereafter be treated “as if never enacted.”

Planning Tip: Use projections and illustrations to show clients how much they can save by acting now.

Conclusion
Yes, there is much uncertainty about our future tax laws, but there is much we do know about current laws. While we are waiting and watching, much can be done to help our clients take advantage of incredible tax-planning opportunities that may never exist again and to help them plan for the taxes we do know we will have in 2013.

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.

When a closely held business is a significant part of a client’s estate, as is often the case, business succession planning becomes an important part of the client’s estate planning. Estate planning issues include how to turn the business into cash for the owner’s retirement, who will take over or buy the business from the owner (family members, an outside buyer, employees, key employees, other owners), and how the sale should be structured.

During the planning process, the advisors may determine that the current type of business entity may not be the correct or most efficient one. Changing the business entity must be done carefully and with full knowledge of the tax consequences.

In this issue of The Wealth Counselor, as we continue our discussion of business succession planning begun in a previous issue, we will look more closely at the income tax issues that must be considered during discussions of a sale or transfer of a closely held business.

Basic Inquiries

On learning that the client owns an interest in a closely held business, there are four basic things the advisor team has to know before it can give the client advice. They are: first, what kind of business entity is involved; second, how is the entity classified for income tax purposes; third, who are the current owners; and fourth and finally, what would the client like to have happen (a) if the client lives to a normal healthy life expectancy or (b) dies early or becomes incapacitated. How much the client’s interest is worth may also be an inquiry to determine how critical planning for the business is to the prospects for success of the client’s planning.

Business Entity Types 

In the U.S., we have only a few kinds of business entities.  They are:

*    Corporations, which includes professional corporations and associations organized to practice a licensed profession (such as law or medicine);

*    General partnerships, which includes unincorporated associations, investment clubs and limited liability partnerships (as distinguished for “limited partnerships” discussed below);

*    Limited partnerships, which includes professional limited liability partnerships;

*    Limited Liability Companies (LLCs), which includes professional LLCs;

*    Sole proprietorships, which really are not separate entities at all, just the owner “doing business as”; and

*    Trusts, which may or may not be treated as separate taxpayers for income tax purposes.

How Is It Classified for Income Tax Purposes?

Knowing the type of business entity involved sometimes does not answer how it is treated for income tax purposes.

Corporations

Corporations are taxed under Subchapter C of Chapter 1 of the Internal Revenue Code (called “C” corporations) unless they elect to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code (called “S” corporations).

C corporations are tax paying entities, just like individuals. They report their income to the IRS each year and pay tax on the net income after deductions. They do not get to deduct dividends paid to their shareholders, and their shareholders in turn must report and pay income tax on those dividends. This is commonly referred to as “double taxation.” S corporations, on the other hand, are tax reportingentities. They report their income or loss to the IRS and to their owners, and then each owner reports his or her share of the income or loss on the owners’ tax return and pays the resulting tax. This income and loss attribution and tax liability results without regard to whether any cash or property is distributed by the corporation to its owners.

Partnerships

Both general partnerships and limited partnerships are classified for income tax purposes the same way—as partnerships. Like S corporations, partnerships are tax reporting entities. They report their income or loss to the IRS and to their owners, and then each partner reports his or her share of the income or loss on the partners’ tax return and pays the resulting tax. The one exception is that in the nine community property states, if the only partners are a husband and wife who file a joint income tax return, they may choose to treat the partnership like a sole proprietorship and disregard its existence for income tax reporting.

Planning Tip: Although both partnerships and S corporations are tax reporting entities, the rules applicable to them are quire different. For example, an S corporation can have no more than 100 owners, all of whom must be U.S. citizens or residents and cannot have different income distribution rules for different classes of owners. Those restrictions do not apply to partnerships.

Limited Liability Companies (LLCs)

LLCs have flexibility. For many years, the IRS went through a complicated rigmarole to determine whether each LLC was more like a partnership or more like a corporation and assigned its taxpayer classification accordingly. Now, the owners of a newly formed LLC have the freedom to “check the box” and thereby choose whether their LLC will be treated for income tax purposes as a corporation (which means it may be eligible to choose S corporation status) or as a partnership. As with partnerships, an LLC owned entirely by a husband and wife who live in a community property state and file jointly may be disregarded for income tax purposes and treated as a sole proprietorship.

Sole Proprietorships

The sole proprietorship is the most common form of business in the United States. Many businesses started from scratch begin as sole proprietorships. Many of them stay as sole proprietorships unless someone on the advisor team points out to the owner the disadvantages of operating as a sole proprietorship—such as liability exposure and limitations on retirement plans. For income tax purposes, a sole proprietorship is not a separate taxpayer. Its revenues and deductions are reported on Schedule C of the owner’s income tax return.

Trusts

Sometimes a sole proprietorship business is started in or transferred to a trust. For income tax purposes, trusts come in two classifications—“grantor trusts,” the income and losses of which are treated for income tax purposes as being those of the person who contributed the assets to the trust, and “non-grantor trusts,” which are treated as separate taxpaying entities for income tax purposes. Some grantor trusts choose to file zero income tax returns and others do not, instead counting on the deemed owner to report the income and deductions on his or her personal income tax return.

Planning Tip: Through careful drafting it is possible to create a trust that is disregarded for income tax purposes, but not for gift and estate tax purposes. Such a trust is sometimes referred to as “intentionally defective” or an “intentional grantor” trust. Almost all ILITs are this type of grantor trust.

Who Are the Owners?

Ownership matters because it can limit the tax planning choices. If a corporation or LLC has any owner who is not a U.S. citizen or resident, it cannot be an S corporation. So, too, if some of its owners have one kind of income right that others do not, the S election is not available to the entity. If the entity is owned by all family members, the planning suggested may be entirely different than if the business is owned by a group who came together for business purposes or who share a common licensed profession.

What Are the Client’s Goals?

Surprisingly, while most clients will have no trouble at all answering the other questions, this one often has never been thought about. The typical owner has his focus on his business and has given little or no thought to how, when, or even if he or she wants to have a life after business.

With careful guidance from the advisor team, the client can be encouraged to focus on the more distant future to do what is possible to preserve the legacy that the business represents, rather than simply closing the doors when the owner is not longer able to run the business.

Planning Tip: This is where the client’s spouse and family may have goals of which the client is unaware. Does a son or daughter assume that they will someday be handed the business “on a silver platter”? Does the spouse envision a life of romantic cruises paid for with the proceeds from selling the business?

There are many, many different strategies for exiting a business other than by closing its doors. In the remainder of this issue we will look at a few of them.

Outright Sale of an Ownership Interest

The client’s ownership interest in the business might be simply sold to a new owner or another existing owner. In that event, the gain or loss on the sale of the ownership interest is taxed as a capital gain or loss.

Exiting a Partnership

Is the business owned by a partnership? If so, the client may wish to reduce their percentage interest in the partnership or leave the partnership entirely. The partnership may accomplish such an ownership reduction or exit by means of a liquidating distribution.

Distributions of cash or marketable securities will cause the receiving partner to recognize capital gain to the extent the amount of cash exceeds the receiving partner’s outside basis (what the selling partner paid for their interest or the basis they received from the senior generation in a gift transaction). The basis may be low relative to the value, especially if the partnership has accumulated assets by investment of income.

When a partner recognizes gain on a distribution because it includes marketable securities that are treated as cash, the partner’s basis in the securities is increased by the amount of the gain recognized. (There is the possibility of a deemed cash distribution under Code Section 752.)

What would otherwise be capital gain is ordinary income if the partnership has “unrealized receivables” and/or “substantially appreciated inventory.” This frequently happens in the case of an auto dealer with inventory.

A partner who contributed property worth more than its basis may have to recognize gain if, within seven years of the contribution, the partnership distributes the contributed property to another partner or the partnership distributes other property to the contributing partner. In general, however, when a partnership distributes property to a partner, neither the partnership nor the receiving partner will recognize gain or loss, because a) the built-in gain or loss in the distributed property will be preserved for later recognition when the receiving partner sells the property or b) the basis of the recipient partner’s partnership interest is reduced by the basis (to him or her) of the distributed property.

Sale of an Interest in a C Corporation

The sale of stock in a C Corporation will result in capital gain or loss to the selling shareholder. The buyer’s basis in the stock is the purchase price. Because underlying corporate assets retain their tax basis regardless of the price paid for the stock, the buyer may “inherit” a substantial future tax liability if the corporation holds appreciated assets. Because of this and the risk of acquiring unknown liabilities in a stock purchase, a buyer of an incorporated business will almost always prefer not purchasing the seller’s stock, opting instead to purchase the assets from the corporation.

The sale of business assets by a C Corporation results in a gain to the corporation and, under current law, is taxed at graduated corporate rates up to 35%. (Corporations generally do not get a special rate for long term capital gains.) The buyer gets a full step up in tax basis of the assets equal to the purchase price. If/when the net after-tax proceeds are distributed out to the shareholders of the selling corporation, the shareholders will have capital gain or loss, depending on the basis of their stock if it is a liquidation or will have dividend income. There is thus a potential Federal tax rate of 45% on such a transaction. That is why a seller would prefer a simple sale of shares resulting in long term capital gains taxed at 15%.

With a going concern, there are both tangible and intangible assets involved in a sale. The intangible assets are the business’ good will and trade secrets and contract rights, such as to distribute a manufacturer’s products or operate under a franchise. With an asset sale, these assets, too, will need to be valued and transferred.

C Corporation Liquidation

Liquidating the C corporation by distributing the assets to the shareholders is generally not advised. It will trigger capital gain income on appreciated assets owned by the corporation and the shareholders will recognize gain on the receipt of corporate assets. The tax bills will have to be paid even though no cash is generated by the transaction. Liquidation of the C corporation is a viable solution if the corporation’s assets are not appreciated and/or shareholders have unused capital losses and/or the corporation has unused NOL carryforwards. In general, if the client simply wants to go out of business and owns a C corporation, it is better to do so in a ten-year plan, as explained below.

Step 1: C Corporation to S Corporation

Make the election to be taxed as an S corporation effective for the corporation’s next tax year. This is a long-range (10-year) plan to eventually eliminate the double taxation that results on the liquidation of a C corporation or conversion to a partnership or an entity taxed as a partnership. Any disposition of corporate assets within this 10-year period—whether by sale, distribution or liquidation—will result in some double taxation, but that is better than all double taxation.

Planning Tip: The current environment of depressed values may make this a good time to make the S election.

Step 2: Liquidate the S Corporation or Convert It to an LLC and Elect Partnership Taxation

Once the ten years has passed, the S corporation can be liquidated or converted to a partnership or LLC taxed as a partnership without enduring the double taxation.

Recapitalization

If the client owns an S corporation or an LLC taxed as an S corporation, a transfer to a family member on favorable terms may often be effected by starting with recapitalization.

S corporation status is only available to a corporation or LLC that has a single class of ownership. However, for these purposes voting interests are not considered to be a different classification than non-voting interests that have the same income and loss attributes. However, although they are considered to be of the same “class,” they can have vastly different values because the right to control the company’s affairs is associated with voting ownership but denied to non-voting ownership. This ability to transfer ownership without control offers an opportunity to shift value on favorable terms and often appeals to the owner who is reluctant to give up control. It can also be used to separate active owners from passive owners, such as children who will not be involved in running the business.

Minimizing Tax on the Sale of Goodwill

Goodwill is an intangible value associated with the going-concern value of a business.

In an asset sale where goodwill is a major component of a company’s value, the double tax sting of a C corporation can sometimes be minimized or eliminated by distinguishing the goodwill owned by the shareholder-employee (personal goodwill) used in the C corporation’s business from the goodwill of the C corporation itself. In such situations, the selling price of the C corporation assets can be split between the C corporation seller and the shareholder seller.

The existence of personal vs. corporate goodwill depends on the contractual relationship between the shareholder-employee and the corporation. There should be no employment, non-competition or other agreements between the shareholder-employee and the corporation that serve to transfer personal good will to the corporation. The business sale negotiations need to reflect two separate sales—that of corporate assets and that of the shareholder-employee’s personal goodwill. Proper allocation, supported by appraisals, is needed between corporate assets being sold and personal goodwill. Any covenant not to compete with the buyer needs to be between the buyer and the shareholder-employee, not the selling corporation.

Planning Tip: To determine the value of goodwill, allocate the purchase price to tangible assets (cash, accounts receivable, inventory and fixed assets) whose value can be verified and documented. Whatever is left can be assigned to the intangibles, which may include goodwill and intellectual property.

Intentionally Defective Grantor Trust (IDGT) and Life Insurance

For a transfer to family members, the owner can establish an intentionally defective grantor trust (IDGT) and sell business interests to the trust. Cash flow from the business that is not needed to service the purchase note can be used to pay premiums on life insurance on the grantor’s life. On the death of the grantor, the insurance proceeds can be used to pay off any unpaid promissory note balance from the sale to the IDGT. Since the grantor is paying taxes on the company earnings flowing into the trust, the trust is in essence using tax-free income to pay the premiums.

Planning Tip: Today’s extremely low AFRs coupled with the asset to value adjustments associated with minority, non-liquid, non-controlling interests in businesses often produce plenty of income in excess of what is needed to service purchase debt.

Buy-Sell Agreements

For businesses other than those owned by members of a single family, there is perhaps nothing more important (nor more likely not to exist) than a good, current buy-sell agreement among the owners. We therefore include a few thoughts on buy-sell agreements.

Triggering events for a buy-sell should include death, disability, deadlock, retirement, attempted sale to a third party and divorce. Anything that would jeopardize the business should also be included, such as disbarment of a member of a law firm. Types of buy-sell agreements include stock redemption (equity purchase), cross purchase (surviving owners purchase), use of a partnership to hold insurance on the lives of multiple shareholders, and a hybrid or wait-and-see combination to give shareholders the right of first refusal.

There are different ways to determine value for the buy-sell agreement. A fixed price method must be updated annually to be useful, and should be supported by an appraisal to avoid disputes. A formula method can include book value, modified book value, capitalization of earnings and discounted future cash flows. Under the appraisal method, a single appraiser can be used, or the buyer and seller can each have an appraiser with any disputes resolved by a third appraiser. A hybrid would be to use a fixed price that defaults to an appraisal if it is not updated.

Funding methods can include retained earnings, sinking fund, installment purchase, third-party borrowing and life insurance. Life insurance is the easiest, but the others should be considered if the shareholder is uninsurable.

Consideration should be given as to whether a selling shareholder should have any obligation to provide the right to other shareholders to participate in that transfer. This would be an appropriate topic when a sale of the company is involved. It would also benefit the minority interests, particularly when all shareholders are entitled to the same price.

Planning Tip: A divorcing owner should have the first opportunity to purchase (over time with interest) the shares the divorce court has awarded to the former spouse before the business or other owners buy the stock. If the owners’ spouses sign the agreement, they can be thus bound.

Tax Issues of Buy-Sell Agreements

Proceeds of life insurance are received income tax-free in most cases. However, life insurance proceeds may cause AMT issues with a C corporation. Premiums paid on insurance to fund buy-sell agreements are never tax deductible, either by the entity or the owners.

Planning Tip: Consider how to handle any excess life insurance proceeds. For example, if the business is valued at $5 million and there is $8 million in life insurance, what would happen to the extra $3 million? Depending on how the agreement is written, it could go back to the corporation as key man insurance or it could be paid out to the deceased shareholder’s estate or beneficiary. There could be a tax issue depending on whether the business is a C corporation or an S corporation.

Transfer Tax Issues:  Under Code Section 2703, the transfer tax value is determined without regard to any buy-sell agreements among family members unless: a) the buy-sell agreement is a bona fide business arrangement; b) it is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; and c) its terms are comparable to similar arrangements entered into by persons in arm’s length transactions. This is a very difficult burden to overcome. As a practical matter, what is paid under almost all buy-sell agreements has no relationship to what the IRS determines to be the value transferred.

S Corporation Issues: The buy-sell agreement among owners of an S corporation needs to contain a number of provisions in order to preserve the S election status of the corporation:

*    Lifetime or testamentary transfers made to trusts for descendants of shareholders or others, only if the trust is either a QSST or an ESBT;

*    Unless elected otherwise, all income and losses for the entire year are allocated on a per day basis.

*    The possibility that a corporate redemption may not qualify for capital gains tax treatment in the hands of the departing shareholder.

*    Prohibit loans, stock options or other transactions which would constitute a second class of stock.

*    Provide that the corporation will make distributions to shareholders at least quarterly to enable payment of estimated income taxes on flow-through income.

Conclusion

It is impossible for one advisor to know everything, which is why the advisory team concept is so important. But the team member who has awareness of the issues associated with a client owning and/or selling a closely held business will be of great value to the team and to the client.