NOVEMBER 2010 TAX PLANING NEWSLETTER

 

 

TO:   ACCOUNTANTS

 

RE:   TAX PLANNING WITH THE CURRENT TAX LEGISLATIVE UNCERTAINTY

 

After the November election, Congress is now split with the House of Representatives controlled by the Republicans and the Senate controlled by the Democrats. To further compound the political situation, the executive branch remains Democratic. This political division will affect income and estate taxes on January 1, 2011 when the sunset provisions of prior tax laws take effect.

Congress in its lame-duck session in November and December 2010 could modify these tax rates prior to December 31, 2010.  However, if Congress enacts no tax legislation before the end of 2010 (or fails to retroactively enact new tax legislation in 2011), then the new tax rates, described below, will apply on January 1, 2011. 

1.       Planning for Income Tax Changes.

If Congress does not enact new tax legislation, then on January 1, 2011 income tax rates are scheduled to change so that:

·         Maximum long-term capital gain rates will increase from 15% to 20%.

 

·         Corporate dividend rates will increase from 15% to 39.6%.

 

·         Maximum tax rates on ordinary income will increase from 35% to 39.6%.

 

Clients accelerating income into 2010 must consider the high California ordinary income and capital gain rate of 9.55% plus the 1% additional California mental health services tax for taxable income in excess of $1,000,000; plus clients must consider the federal alternative minimum tax.

Additionally, in 2013, a new 3.8% Medicare tax on unearned income (which means investment income such as rents, interest, dividends, and capital gains on investment assets) is scheduled to apply to individuals.  This new Medicare tax will apply at $250,000 for joint returns, $125,000 for married persons filing separately, and $200,000 for other individual taxpayers.  Thus, for clients in the highest tax bracket starting in 2013, dividends could be subject to a federal tax of 43.4% (39.6% + 3.8%) plus a California income tax of 10.55% (9.55% + 1%).  These high tax bracket clients might not be able to utilize the federal deduction for state income taxes because of the federal alternative minimum tax.

Assuming no tax legislation is enacted for 2011 (so that the higher tax rates apply), clients should consider the following tax planning ideas:

·        Take advantage of the lower 2010 income tax rates by accelerating income to 2010 through collecting accounts receivable or paying compensation bonuses in 2010 and deferring deductions until 2011.  Because in 2011, the phase out of itemized deductions on personal income tax returns may again apply, it may be prudent to move clients’ itemized deductions into 2010 where there is no phase out applicable.[1]

 

·        If a client holds long term capital gain assets, it may be preferable to sell those assets (such as appreciated stock) in 2010 utilizing the low 15% federal capital gain rate.  The client can always buy the sold stock right back if the client believes that stock may appreciate in value in the future.

 

·        If there is a sale under an installment promissory note in 2010, clients can elect out of the installment sale method in order to accelerate the note’s income into 2010.

 

·        Because of the increase in dividend income tax rates in 2011 and the new Medicare tax of 3.8% beginning in 2013, this will discourage investments in stocks which pay dividends and will encourage investment in tax free municipal bonds.  The economic effect of the larger tax on dividends may be that corporations elect to pay smaller dividends, thus, producing lower yields on certain stocks.

 

·        Plan to avoid the new Medicare tax (which begins in 2013) by creating operating businesses where a partner or LLC member actively participates in the business’s activities.

 

·        Convert a 401K plan or a traditional IRA plan into a Roth IRA, thereby, accelerating income to 2010 allowing the earnings of the Roth IRA to be distributed tax free in future years.  The advantage of converting to a Roth IRA is that beginning in 2010 there is no longer an adjusted gross income limitation to effectuate this Roth IRA conversion, and in 2010 there are lower income tax rates.  In a Roth IRA, the account accumulates tax free and there is no tax when amounts are withdrawn from an IRA (both on the contributed amount and on any earnings in the account) where the Roth IRA account is distributed after being held at least five years and after age 59 ½ or death.  Importantly, there are no minimum withdrawals from the Roth IRA account at age 70 ½.  Another advantage of converting in 2010 is that the client only has to pay the income tax on one-half of the amount for the conversion in 2011 and the other half in 2012 (however, taxpayers may not want to take advantage of this tax deferral since the tax rates in 2010 are lower).

 

2.       Tax Planning with the New Internal Revenue Code Economic Substance Doctrine.

New Internal Revenue Code §7701(o) codifies the “economic substance doctrine” and imposes a new 40% penalty if a transaction lacks economic substance or fails to meet the requirements of any similar rule of law (the penalty is reduced to 20% if the taxpayer discloses the relevant facts on their tax return).[2]  Under this new Code Section, a tax planning transaction would not have economic substance unless both: (i) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and (ii) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.  This new Internal Revenue Code Section has put “fear” into many taxpayers because of the high 40% penalty amount.  However, comfort can be found in the legislative history which says that this new statute is not intended to alter the tax treatment of basic business transactions as well as comments orally made by IRS representatives stating that this new Code provision is not intended to modify existing tax laws.[3]  For example, Deborah Butler, Associate Chief Counsel of the IRS, recently stated at the November, 2010 meeting at the State Bar of California Taxation Section, that §7701(o) was not intended to change existing law. 

3.       Planning in Light of the Uncertainty in the Estate and Generation- Skipping Transfer Tax Area.

This year in 2010, there is no federal estate tax nor any generation-skipping transfer tax.  The gift tax this year, in 2010, is a low 35% rate with a gift tax applicable exclusion amount of $1,000,000.  Additionally, in 2010, there is a modified carried over income tax basis for decedents who have died in 2010.[4] 

In 2011 and thereafter, current tax law provides a low gift and estate tax exclusion amount of $1,000,000, a generation-skipping transfer tax exemption (because of inflation adjustments) between $1,300,000 and $1,400,000; and a high gift and estate tax rate of 55%.[5]  In 2011, there is also a state death tax credit.  During 2010, numerous estate tax bills were proposed in Congress, but no estate tax legislation has passed to date.

Family Partnerships, properly formed and operated, continue to be recognized by the Courts as viable entities to reduce clients’ estate and gift taxes through lack of marketability and lack of control valuation discounts.[6]

Thus, in light of the 2011 scheduled changes to estate taxes clients should consider the following estate planning ideas:

·        Review their estate plan marital deduction formula and the generation-skipping tax formula exemption amounts to be sure that these formulas work in the manner that clients intend under the new 2011 estate and gift tax rules. 

·        With the large increase in estate tax rates to 55% and the low exclusion amount, clients starting in 2011 should consider reducing any estate and generation-skipping tax exposure by transferring their assets to their children and grandchildren by gifts and sales, utilizing GRATs[7] and defective grantor income trusts, creating family partnerships and limited liability companies, and using other gifting techniques.

·        Clients should continue to utilize the annual gift tax exclusion amount of $13,000 per donee per year ($26,000 per donee for a husband and wife making gifts).  Additionally, clients can continue to pay the school tuition and medical expenses of their children and grandchildren gift tax free.

CONCLUSION.

 Year end 2010 tax planning presents difficult choices for clients due to the tax rate sunset provisions and the uncertainty of future tax legislation.

 

 

 

 

 

 

 

 

 

 

 

IRS CIRCULAR 230 DISCLOSURE:  To ensure compliance with Treasury Department regulations, we inform you that any U.S. Federal tax advice contained in this Newsletter is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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[1]  Itemized deductions in 2011 will be in part reduced by the lesser of 3% of adjusted gross income of an excess of inflation adjustment amount (which was an adjusted amount $166,800 in 2009) or 80% of itemized deductions.  Medical expenses, investment interests, and casually and theft losses are exempt from this 2011 itemized deduction limitation.

[2]  See §6662.  No exceptions to this penalty apply.  Thus, “reasonable cause” is not an available exception.

 

[3]  In IRS Notice 2010-62, the IRS stated that it would not issue guidance regarding the types of transactions to which the economic substance doctrine applied or did not apply, nor would the IRS issue Private Letter Rulings regarding the economic substance doctrine under the new code §7701(o).  One concern of tax practitioners is that this new code section states that the economic substance doctrine is to be applied in a conjunctive fashion.

 

[4]  For a person dying during 2010, subject to certain exceptions, the property’s income tax basis will no longer be its estate tax value, and instead will be the lesser of: (i) the decedent’s adjusted tax basis in the property; or (ii) the fair market value of that property at date of death.  This modified carry over income tax basis permits assets’ tax bases to be increased by up to $1,300,000.  Additionally, there are further increases for unused capital losses, operating losses, and certain built-in losses of the decedent.  Finally, there is a further $3,000,000 income tax basis increase for assets transferred to a surviving spouse either outright or in a QTIP trust.

 

[5]  Additionally, there is a 5% surtax for estates between $10,000,000 and $17,000,000 in order to phase out the benefits of lower estate tax rates and the estate tax exemption amount.

 

[6]  See, for example Holman, 130 TC 170 (2008), affd 105 AFTR2d 2010-1802 (8th Circ., 2010).

[7]  Although tax legislation has been introduced into Congress to impose a ten year minimum term for GRATs, no such tax law has been passed.