The answer is: it depends.
We have two co-existing estate tax systems in place for 2010. One system imposes no federal estate tax, but at the cost of putting limits on the step-up of any inherited assets. The other imposes an estate tax, but with no limit on the step-up. The estate gets to decide.
We are used to thinking that the tax basis of an inherited tax asset is the value on the date of death. The idea is that the estate already paid tax, so to have the beneficiary pay tax again on any sale soon after the death would be unfair. The estate therefore gets to step-up the basis of the asset, preventing any appreciation in the asset (through the date of death) from being taxed again.
The dividing line is $5 million. When Congress changed the law late in 2010, it resurrected the estate tax but with a $5 million exemption. Therefore, an estate under $5 million would opt-in to the new tax law, increase the basis of any assets and pay no federal tax. Best result!
An estate over $5 million has to decide. If it opts-in, then there will be federal estate tax to pay. If it opts-out, there will be no federal estate tax but the step-up may be limited. The limits are as follows:
(1) All estates get a step-up up to $1.3 million
If the appreciation is $1.3 million or less, then the estate would opt-in. The end result is the same as opting out, as there is only so much step-up in the assets anyway.
If the appreciation is more than $1.3 million, then step-up is limited. And the estate has a decision to make.
(2) If there is a surviving spouse and the spouse receives estate assets…
Then there is an additional $3 million step-up for assets passing to the surviving spouse.
How would a beneficiary know what the estate did? Well, there is a new form – Form 8939. The executor of the (larger) estate will fill-out this form and send a copy to the beneficiaries. The problem is that the form has not yet been finalized by the IRS. If one sold an asset in 2010 – and that asset was inherited from someone who passed way in 2010 – it is likely that he/she will have to file for an income tax extension and wait on receiving this form from the executor.
Tuesday, June 21, 2011
The 2011 & 2012 Gift Tax Exemption
The lifetime gift tax exemption has been increased from $1,000,000 to $5,000,000 but only for 2011 and 2012. Is it worth taking advantage of the new exemption amounts? Definitely.
Let me preface by admitting the obvious: those amounts are way beyond the level most of us can gift. Nonetheless, there are people who can, and it is those people who hire tax CPAs - such as yours truly.
Why the rush? Well, who knows what Congress will do? We do know that these exemptions are available for the better part of two more years. When coupled with other tax techniques that can leverage the exemption amount, such as family limited partnerships or retained interest trusts, the opportunity for substantial family wealth transfers with no or minimal transfer tax consequence exists.
There is an issue here that has bothered the tax community. The estate tax is calculated by summarizing the taxable estate and adding-back any lifetime taxable gift transfers. If the gift exemption returns to $1,000,000 in the future, how will one calculate the “lifetime taxable gift transfers?” Will it be the excess over $5,000,000, as it is now, or will it be the exemption level in the year of death (say that level returns to $1,000,000)? I have read no serious tax commentator who expects that whipsaw to occur.
It is however a sad indictment of the instability of our tax system that such a question is even raised.
Let me preface by admitting the obvious: those amounts are way beyond the level most of us can gift. Nonetheless, there are people who can, and it is those people who hire tax CPAs - such as yours truly.
Why the rush? Well, who knows what Congress will do? We do know that these exemptions are available for the better part of two more years. When coupled with other tax techniques that can leverage the exemption amount, such as family limited partnerships or retained interest trusts, the opportunity for substantial family wealth transfers with no or minimal transfer tax consequence exists.
There is an issue here that has bothered the tax community. The estate tax is calculated by summarizing the taxable estate and adding-back any lifetime taxable gift transfers. If the gift exemption returns to $1,000,000 in the future, how will one calculate the “lifetime taxable gift transfers?” Will it be the excess over $5,000,000, as it is now, or will it be the exemption level in the year of death (say that level returns to $1,000,000)? I have read no serious tax commentator who expects that whipsaw to occur.
It is however a sad indictment of the instability of our tax system that such a question is even raised.
North Carolina Drops Lawsuit Against Amazon
You probably are aware that online vendors – such as Amazon – do not charge sales tax to customers outside their home state. You also know that this has created much the controversy with the states, ever eager to tax to anything that moves within their borders. To be fair, if a person went a sticks-and-bricks store to purchase an item, the transaction would be sales taxable. It is the intermediation of the internet that presents the problem. And it is a problem. For example, I recently purchased an item from Britain. Would it be reasonable for that vendor to charge me Kentucky sales tax, as I live in Kentucky and the transaction would otherwise go untaxed?
Take a start-up company, say Hamilton Educational (HE). HE makes and sells educational accounting videos of captivating content and quality. HE sets up a little website; its fame spreads; soon its videos are in intense demand and sold to every corner of the country. Is it fair, or even practicable, for HE to monitor its sales tax obligation to every state in the nation? What is the cost of this compliance? Does this cost outweigh any benefit to (name) the state? Has HE died before its birth, unable to comply with the administrative burden of its successful business model?
Enter North Carolina (NC). NC went after Amazon, requesting records of Amazon’s transactions with North Carolina residents. Think about this for a moment. The state is forcing a company to release its records about you. You are not involved in the litigation; heck, you are not even aware of the litigation. The privacy concern here is staggering.
The American Civil Liberties Union joined in a lawsuit against NC, and very recently NC settled the case. The state agreed to pay almost $100,000 in legal fees and ceased its action, but it reserved the right to go against Amazon and/or its customers in the future.
North Carolina had previously gone after Amazon for sales tax on the argument of economic nexus. This means that a company has “nexus” with a state if it derives a financial benefit from commercial transactions within that state. This is an interesting argument, in that a variation of that argument would subject me to New Zealand taxes for ordering the Lord of the Rings video trilogy. In Amazon’s case, NC argued that the economic nexus was provided by the affiliates, which are blogs or other online sites that provide links to products and/or offer coupons. I listen to online radio, for example. If a particular song captures my ear, I can click on the site, find out the artist and likely have a link to purchase the artist’s CD. That is an example of an affiliate.
Amazon cut its ties to its North Carolina affiliates in response.
North Carolina continued to chase Amazon for taxes before those affiliate ties were severed, resulting in the settlement mentioned above.
Do you see any winner in this story?
Take a start-up company, say Hamilton Educational (HE). HE makes and sells educational accounting videos of captivating content and quality. HE sets up a little website; its fame spreads; soon its videos are in intense demand and sold to every corner of the country. Is it fair, or even practicable, for HE to monitor its sales tax obligation to every state in the nation? What is the cost of this compliance? Does this cost outweigh any benefit to (name) the state? Has HE died before its birth, unable to comply with the administrative burden of its successful business model?
Enter North Carolina (NC). NC went after Amazon, requesting records of Amazon’s transactions with North Carolina residents. Think about this for a moment. The state is forcing a company to release its records about you. You are not involved in the litigation; heck, you are not even aware of the litigation. The privacy concern here is staggering.
The American Civil Liberties Union joined in a lawsuit against NC, and very recently NC settled the case. The state agreed to pay almost $100,000 in legal fees and ceased its action, but it reserved the right to go against Amazon and/or its customers in the future.
North Carolina had previously gone after Amazon for sales tax on the argument of economic nexus. This means that a company has “nexus” with a state if it derives a financial benefit from commercial transactions within that state. This is an interesting argument, in that a variation of that argument would subject me to New Zealand taxes for ordering the Lord of the Rings video trilogy. In Amazon’s case, NC argued that the economic nexus was provided by the affiliates, which are blogs or other online sites that provide links to products and/or offer coupons. I listen to online radio, for example. If a particular song captures my ear, I can click on the site, find out the artist and likely have a link to purchase the artist’s CD. That is an example of an affiliate.
Amazon cut its ties to its North Carolina affiliates in response.
North Carolina continued to chase Amazon for taxes before those affiliate ties were severed, resulting in the settlement mentioned above.
Do you see any winner in this story?
An ESOP Fable
Several years back there was a nifty tax-planning technique calling for the use of an ESOP as a shareholder or partner in an S corporation or partnership/LLC. You will remember that an ESOP is a qualified retirement plan and pays no taxes. To the extent that the ESOP is top-heavy - meaning that the key employees of the sponsoring employer own the majority of ESOP – this is quite the nifty tax technique. Leverage the ESOP and make the bank payments deductible as retirement contributions. These payments reduce the sponsor’s taxable income. Combine this with an ESOP on the receiving end – an entity which does not pay tax – and you have fields of tax gold.
Of course, someone has to push this to the limit and get slapped down.
Enter the law firm Renkemeyer, Campell & Weaver, LLP. These guys are based in Kansas and have a tax year ending April 30. For year 4/30/04 the firm had three attorney/shareholders and an S corporation as the fourth shareholder. The S corporation was owned by an ESOP.
The profit percentages were 30-30-30-10, with the S having the 10%.
The revenues were approximately 33-33-33-1, with the S having the 1%.
Oh, you can see this coming, you say?
Well, the law firm allocated approximately 88% of its income to the S corporation for year 4/30/04. You have probably already guessed that the only – or least predominant – participants in the ESOP were the three attorneys.
The IRS examined the year and said “you have to be kidding.” A tax CPA would phrase that to say that the transaction does “not reflect economic reality.” Accordingly, the IRS reallocated the law firm's net business income to its partners on the basis of their respective profit and loss interests.
The attorneys disagreed, and the case went to the Tax Court. The court held that the law firm failed to show that its special allocation (of income to the S corporation) was proper. The firm could (theoretically) have won the argument with the IRS, but it had to present some cogent economic argument for shifting almost 90% of its income to an entity which did virtually nothing. It did not. The court moved income from a tax-exempt entity (the S/ESOP) to the three individual partners. This resulted in individual income taxes. In addition, the income represented self-employment earnings to the three partners, which meant that they also owed self-employment taxes.
They pushed too far.
Of course, someone has to push this to the limit and get slapped down.
Enter the law firm Renkemeyer, Campell & Weaver, LLP. These guys are based in Kansas and have a tax year ending April 30. For year 4/30/04 the firm had three attorney/shareholders and an S corporation as the fourth shareholder. The S corporation was owned by an ESOP.
The profit percentages were 30-30-30-10, with the S having the 10%.
The revenues were approximately 33-33-33-1, with the S having the 1%.
Oh, you can see this coming, you say?
Well, the law firm allocated approximately 88% of its income to the S corporation for year 4/30/04. You have probably already guessed that the only – or least predominant – participants in the ESOP were the three attorneys.
The IRS examined the year and said “you have to be kidding.” A tax CPA would phrase that to say that the transaction does “not reflect economic reality.” Accordingly, the IRS reallocated the law firm's net business income to its partners on the basis of their respective profit and loss interests.
The attorneys disagreed, and the case went to the Tax Court. The court held that the law firm failed to show that its special allocation (of income to the S corporation) was proper. The firm could (theoretically) have won the argument with the IRS, but it had to present some cogent economic argument for shifting almost 90% of its income to an entity which did virtually nothing. It did not. The court moved income from a tax-exempt entity (the S/ESOP) to the three individual partners. This resulted in individual income taxes. In addition, the income represented self-employment earnings to the three partners, which meant that they also owed self-employment taxes.
They pushed too far.
College Financial Aid and Taxes
College financial aid applications have appeared in the office. This is somewhat an annual exercise for us, but let’s take the opportunity to review the tax implications of financial aid.
First, don’t let the terms mislead you. For example, a student may receive a “grant”, a “scholarship” or a “fellowship.” With only this information, I cannot tell you what the tax consequence is going to be. There are two key issues here. First, does the recipient (or someone) have to pay the money back? If the answer is yes, you have a loan and there is no taxable income. Loans are generally not considered income, as there has been no addition to wealth.
Say you don’t have to pay it back. Second question: does the recipient have to work in order to receive it? If the answer is yes, then it doesn’t matter what it is called – grant, scholarship, fellowship or tuition reduction – the recipient has income. He or she can expect a W-2 at year-end. Now, this doesn’t mean that there will be federal tax due. It may be that the W-2 does not exceed the recipient’s standard deduction and personal exemption, for example. Or it may be that the recipient claims an education tax credit which more than offsets any federal tax.
By the way, the tax consequence does not drive-off the source of the money. The IRS is not concerned whether the financial aid comes from a government agency, a nonprofit or a corporation.
If the recipient does not have to repay or work, then the aid is nontaxable as long as:
(1) The recipient is a degree candidate
(2) The aid is restricted for tuition and related expenses OR the aid is NOT restricted for something OTHER THAN tuition and related expenses.
(3) The recipient has to actually incur tuition and related expenses, and those expenses have to exceed the financial aid.
There is a combination where the recipient does not have to repay or work and yet has taxable income. How? It’s not intuitive, I grant you.
Notice the language in (2) above: “tuition and related expenses.” What expense is not related? Room and board is the biggie here. To the extent that the recipient receives non-loan, non-W-2 financial aid AND the aid exceeds the cost of tuition, fees, books and supplies, the recipient has income. The translation is that aid for room and board is taxable.
Let’s use an example. Say that Meadow Soprano receives a scholarship to attend Big Name U. She receives $45,000 aid for the academic year, and she is not obligated to repay or work. Her tuition, fees books and supplies are $36,500. Meadow has $8,500 ($45,000 – 36,500) of taxable income.
First, don’t let the terms mislead you. For example, a student may receive a “grant”, a “scholarship” or a “fellowship.” With only this information, I cannot tell you what the tax consequence is going to be. There are two key issues here. First, does the recipient (or someone) have to pay the money back? If the answer is yes, you have a loan and there is no taxable income. Loans are generally not considered income, as there has been no addition to wealth.
Say you don’t have to pay it back. Second question: does the recipient have to work in order to receive it? If the answer is yes, then it doesn’t matter what it is called – grant, scholarship, fellowship or tuition reduction – the recipient has income. He or she can expect a W-2 at year-end. Now, this doesn’t mean that there will be federal tax due. It may be that the W-2 does not exceed the recipient’s standard deduction and personal exemption, for example. Or it may be that the recipient claims an education tax credit which more than offsets any federal tax.
By the way, the tax consequence does not drive-off the source of the money. The IRS is not concerned whether the financial aid comes from a government agency, a nonprofit or a corporation.
If the recipient does not have to repay or work, then the aid is nontaxable as long as:
(1) The recipient is a degree candidate
(2) The aid is restricted for tuition and related expenses OR the aid is NOT restricted for something OTHER THAN tuition and related expenses.
(3) The recipient has to actually incur tuition and related expenses, and those expenses have to exceed the financial aid.
There is a combination where the recipient does not have to repay or work and yet has taxable income. How? It’s not intuitive, I grant you.
Notice the language in (2) above: “tuition and related expenses.” What expense is not related? Room and board is the biggie here. To the extent that the recipient receives non-loan, non-W-2 financial aid AND the aid exceeds the cost of tuition, fees, books and supplies, the recipient has income. The translation is that aid for room and board is taxable.
Let’s use an example. Say that Meadow Soprano receives a scholarship to attend Big Name U. She receives $45,000 aid for the academic year, and she is not obligated to repay or work. Her tuition, fees books and supplies are $36,500. Meadow has $8,500 ($45,000 – 36,500) of taxable income.
The Retirement Savers Credit
If you contribute to a 401(k), SEP, SIMPLE, IRA or Roth and have modest income, there may be a federal tax credit for you. It is the “credit for qualified retirement savings,” shortened to the savers credit in practice. The credit can be as much as $1,000 per person and phases out as your income rises.
If you are single, the credit phases-out at $27,750. For head-of-household it is $41,625 and for marrieds it is $55,500.
You claim the credit on Form 8880. There are some restrictions, such as you cannot be a full-time student or be claimed as a dependent.
By the way, you may overlook this credit if you file a 1040-EZ, as the form does not have a line for it.
If you are single, the credit phases-out at $27,750. For head-of-household it is $41,625 and for marrieds it is $55,500.
You claim the credit on Form 8880. There are some restrictions, such as you cannot be a full-time student or be claimed as a dependent.
By the way, you may overlook this credit if you file a 1040-EZ, as the form does not have a line for it.
An ESOP Too Far
Every now and then I read a tax case or summary that takes my breath away. I came across one recently. It has to do with an employee stock ownership plan (ESOP). ESOPs are specialized retirement plans. They are funded with company stock rather than with cash. As a participant in such a plan, your account would represent company shares. There is a way to turbocharge an ESOP by having the plan borrow money to buy the stock. The company sponsoring the plan then pays dividends, and the plan would use the dividends to repay the bank loan. I’ve seen a couple of ESOPs since I’ve been in Cincinnati. In my experience they have served primarily as a way to cash-out existing shareholders.
Back to our story. There is a dentist in Iowa. We’ll call him Michael C. Hollen. He incorporated his dental practice (Hollen PSC). The PSC began sponsoring an ESOP on 11/1/86. The plan chose a fiscal year-end of October, so its first and initial plan year was 10/31/87.
In 10/89, the plan borrowed approximately $415,000 and used those funds to purchase stock of Hollen PSC. Hollen PSC in turn contributed approximately $200,000 to the ESOP, which the plan put to good use by paying down its debt.
Problem One:
The plan allocated over $150,000 of the $200,000 to Dr. Hollen’s account. There are rules and regulations here. For this year, the “annual addition” limit was $30,000 or 25% of a participant’s compensation. Dr Hollen thought he got around this problem by calling the $200,000 a “dividend.” Generally, the annual addition would not include a dividend, but the IRS reserves the right to recharacterize a transaction if required to combat abuse. The court took pains to explain that it could not glance askance from a $200,000 “dividend,” especially where $150,000 went to Dr Hollen on a tax-deductible basis. This is a way of saying “abuse.”
The PSC hired Stephen Thielking, a CPA, as the plan’s accountant. Thielking appraised the stock held by the ESOP in 2001, 2002, and 2003. ESOPs have to appraise the stock.
Problem Two:
The IRS has procedures for one to be a “qualified” appraiser and eligible to do appraisals for an ESOP. Mr. Thielking could not be bothered with such trifling matters as following the procedures to be considered a qualified appraiser.
The Small Business Jobs Act of 1996 and the IRS Restructuring and Reform Act of 1998 amended any number of Code plan provisions. When this happens, plans are permitted a certain amount of time to review their documents and procedures and bring them into compliance.
Problem Three:
This was not done. More correctly, some of this was done but not all.
Qualified plans have to vest contributions in the participants. Vesting means that the employee has rights to an amount and can take it with him/her upon leaving the company.
Problem Four:
The plan did not keep its books on the same vesting schedule as its plan documents required. For reasons beyond my ken, the plan declined the IRS’ offer to participate in a closing agreement program (CAP), which would allow for retroactive compliance on this issue.
It appears clear to me that the court did not sympathize with Dr Hollen at all. The court twice disapprovingly mentioned Hollen’s failure to correct plan defects through the IRS-provided CAP program. In one footnote it sniffed that Dr Hollen had made assertions that “the record does not substantiate…” The court also swiped that Dr Hollen “offers no explanation why the vesting schedules … did not follow that schedule.”
So what happened? The Court disqualified the plan from inception – all the way back to 1987. The consequences are mind-boggling. The corporation took deductions to which it was not entitled. The plan contributions would represent taxable income to the participants, as there is no qualified plan to receive the contributions. A plan has to be qualified to defer tax recognition. Corporate returns have to be amended. Individual returns have to be amended. The penalties alone would be staggering.
Back to our story. There is a dentist in Iowa. We’ll call him Michael C. Hollen. He incorporated his dental practice (Hollen PSC). The PSC began sponsoring an ESOP on 11/1/86. The plan chose a fiscal year-end of October, so its first and initial plan year was 10/31/87.
In 10/89, the plan borrowed approximately $415,000 and used those funds to purchase stock of Hollen PSC. Hollen PSC in turn contributed approximately $200,000 to the ESOP, which the plan put to good use by paying down its debt.
Problem One:
The plan allocated over $150,000 of the $200,000 to Dr. Hollen’s account. There are rules and regulations here. For this year, the “annual addition” limit was $30,000 or 25% of a participant’s compensation. Dr Hollen thought he got around this problem by calling the $200,000 a “dividend.” Generally, the annual addition would not include a dividend, but the IRS reserves the right to recharacterize a transaction if required to combat abuse. The court took pains to explain that it could not glance askance from a $200,000 “dividend,” especially where $150,000 went to Dr Hollen on a tax-deductible basis. This is a way of saying “abuse.”
The PSC hired Stephen Thielking, a CPA, as the plan’s accountant. Thielking appraised the stock held by the ESOP in 2001, 2002, and 2003. ESOPs have to appraise the stock.
Problem Two:
The IRS has procedures for one to be a “qualified” appraiser and eligible to do appraisals for an ESOP. Mr. Thielking could not be bothered with such trifling matters as following the procedures to be considered a qualified appraiser.
The Small Business Jobs Act of 1996 and the IRS Restructuring and Reform Act of 1998 amended any number of Code plan provisions. When this happens, plans are permitted a certain amount of time to review their documents and procedures and bring them into compliance.
Problem Three:
This was not done. More correctly, some of this was done but not all.
Qualified plans have to vest contributions in the participants. Vesting means that the employee has rights to an amount and can take it with him/her upon leaving the company.
Problem Four:
The plan did not keep its books on the same vesting schedule as its plan documents required. For reasons beyond my ken, the plan declined the IRS’ offer to participate in a closing agreement program (CAP), which would allow for retroactive compliance on this issue.
It appears clear to me that the court did not sympathize with Dr Hollen at all. The court twice disapprovingly mentioned Hollen’s failure to correct plan defects through the IRS-provided CAP program. In one footnote it sniffed that Dr Hollen had made assertions that “the record does not substantiate…” The court also swiped that Dr Hollen “offers no explanation why the vesting schedules … did not follow that schedule.”
So what happened? The Court disqualified the plan from inception – all the way back to 1987. The consequences are mind-boggling. The corporation took deductions to which it was not entitled. The plan contributions would represent taxable income to the participants, as there is no qualified plan to receive the contributions. A plan has to be qualified to defer tax recognition. Corporate returns have to be amended. Individual returns have to be amended. The penalties alone would be staggering.
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