June 29, 2022
Is your corporation eligible for the dividends-received deduction?
There’s a valuable tax deduction available to a C corporation when it receives dividends. The “dividends-received deduction” is designed to reduce or eliminate an extra level of tax on dividends received by a corporation. As a result, a corporation will typically be taxed at a lower rate on dividends than on capital gains.
Ordinarily, the deduction is 50% of the dividend, with the result that only 50% of the dividend received is effectively subject to tax. For example, if your corporation receives a $1,000 dividend, it includes $1,000 in income, but after the $500 dividends-received deduction, its taxable income from the dividend is only $500.
The deductible percentage of a dividend will increase to 65% of the dividend if your corporation owns 20% or more (by vote and value) of the payor’s stock. If the payor is a member of an affiliated group (based on an 80% ownership test), dividends from another group member are 100% deductible. (If one or more members of the group is subject to foreign taxes, a special rule requiring consistency of the treatment of foreign taxes applies.) In applying the 20% and 80% ownership percentages, preferred stock isn’t counted if it’s limited and preferred as to dividends, doesn’t participate in corporate growth to a significant extent, isn’t convertible and has limited redemption and liquidation rights.
If a dividend on stock that hasn’t been held for more than two years is an “extraordinary dividend,” the basis of the stock on which the dividend is paid is reduced by the amount that effectively goes untaxed because of the dividends-received deduction. If the reduction exceeds the basis of the stock, gain is recognized. (A dividend paid on common stock will be an extraordinary dividend if it exceeds 10% of the stock’s basis, treating dividends with ex-dividend dates within the same 85-day period as one.)
Holding period requirement
The dividends-received deduction is only available if the recipient satisfies a minimum holding period requirement. In general, this requires the recipient to own the stock for at least 46 days during the 91-day period beginning 45 days before the ex-dividend date. For dividends on preferred stock attributable to a period of more than 366 days, the required holding period is extended to 91 days during the 181-day period beginning 90 days before the ex-dividend date. Under certain circumstances, periods during which the taxpayer has hedged its risk of loss on the stock are not counted.
Taxable income limitation
The dividends-received deduction is limited to a certain percentage of income. If your corporation owns less than 20% of the paying corporation, the deduction is limited to 50% of your corporation’s taxable income (modified to exclude certain items). However, if allowing the full (50%) dividends-received deduction without the taxable income limitation would result in (or increase) a net operating loss deduction for the year, the limitation doesn’t apply.
Illustrative example
Let’s say your corporation receives $50,000 in dividends from a less-than-20% owned corporation and has a $10,000 loss from its regular operations. If there were no loss, the dividends-received deduction would be $25,000 (50% of $50,000). However, since taxable income used in computing the dividends-received deduction is $40,000, the deduction is limited to $20,000 (50% of $40,000). Other rules apply if the dividend payor is a foreign corporation.
June 29, 2022
Add estate planning flexibility with a power of appointment
The best laid plans can go awry. After your death, events may transpire that you hadn’t anticipated or couldn’t have reasonably foreseen. There’s no way of predicting the future, but you may want to supplement your existing estate plan with a trust provision that gives a designated beneficiary a “power of appointment” over some or all of the trust property. Essentially, this person will have the discretion to change distributions from the trust or even add or subtract beneficiaries.
Assuming the holder of this power fulfills the duties properly, he or she can make informed decisions when all the facts are known. This can create more flexibility and adaptability within your estate plan.
2 types of powers
There are two types of powers of appointment:
“General” power of appointment. A general power of appointment allows the holder to distribute assets to anyone, including him- or herself, his or her estate or the estate’s creditors. The property is usually included in a trust but may be given to the holder outright. Also, this power of appointment can be transferred to another person.
“Limited” or “special” power of appointment. Here, the person holding the power of appointment can give the property to a select group of people who’ve specifically been identified by the deceased. For example, it might provide that a surviving spouse can give property to surviving children, as he or she chooses, but not to anyone else. Thus, this power is more restrictive than a general power of appointment.
Whether you should use a general or limited power of appointment depends on your circumstances and expectations.
Tax impacts
The resulting tax impact may also affect your decision to use a general or limited power of appointment. The rules are complicated, but property subject to a general power of appointment is typically included in the taxable estate of the designated holder of the power. However, property included in the deceased’s estate currently receives a step-up in basis to fair market value on the date of death. Therefore, your heirs can sell property that was covered by a general power of appointment with little or no income tax consequences.
In contrast, property covered by a limited power isn’t included in the holder’s estate. However, the heirs inherit the property with a carryover basis and no step-up in basis. So, if the heirs sell appreciated property, they may be liable for high capital gains taxes.
Generally, if estate tax isn’t a concern, a general power of appointment may be preferable. We can help you determine if adding a power of appointment is right for your situation.
© 2022
June 29, 2022
CLTs: A charitable trust that takes the lead
Are you inclined to donate assets to a charity for a period of time without ultimately giving up the property? Consider the benefits of a charitable lead trust (CLT). This type of trust is essentially the opposite of the charitable remainder trust (CRT), a better-known alternative.
With a CLT, the property eventually reverts to your family members — not the charity. At the same time, the CLT provides a stream of annual income to the charity for a term of years.
A CLT in action
A CLT may be funded during your lifetime, or a testamentary trust can be created through your will or other estate planning documents. In either case, the trust is irrevocable. You can incorporate this technique into your estate plan to accommodate charitable intentions.
The basic premise is relatively simple although the mechanics can be complicated. Generally, you contribute property to a trust drafted to last for a specific number of years. The charity (or group of charities) designated as the income beneficiary receives payouts during the trust term.
Depending on the CLT’s structure, payments are made as fixed annuity payments or a percentage of the trust. When the trust term expires, the remaining assets are distributed to the designated beneficiaries.
Charitable deduction implications
One of the main attractions of a CRT is that you can claim a current tax deduction for the value of the remainder interest. However, if you use a CLT, your deduction may be limited or nonexistent, depending on whether it’s a grantor or nongrantor trust.
With a grantor CLT, you can claim a current deduction for the present value of the future payments to the charitable beneficiary, subject to other applicable deduction limits. However, there’s a downside to this arrangement: The investment income generated by the trust is taxable to the grantor during the term.
Conversely, if the CLT is set up as a nongrantor trust, the trust itself — not the grantor — is treated as the owner of the assets. As a result, the trust is liable for the tax due on the undistributed income. Thus, the trust, but not the grantor, can claim the charitable deduction for distributions to the charitable organization. Each situation is different, but the resulting income tax liability for a grantor trust often outweighs the benefit of the current tax deduction.
Note that a properly structured CLT will produce a gift or estate tax deduction for the value of that portion of the trust designated for charity. This makes it possible to transfer a remainder interest to family members at a relatively low tax cost.
Ins and outs
The CLT must provide annual payments to at least one designated charity for a specific number of years, the life of one or more individuals, or a combination of the two. Unlike a CRT, there’s no mandatory timeframe of 20 years, nor does the trust have to impose maximum or minimum requirements each year. When the trust term finally expires, the remainder passes to the designated beneficiaries named at the outset.
Is a CLT right for you? It depends on your circumstances. Discuss this option with us.
© 2022
June 22, 2022
Help when needed: Apply the research credit against payroll taxes
Here’s an interesting option if your small company or start-up business is planning to claim the research tax credit. Subject to limits, you can elect to apply all or some of any research tax credits that you earn against your payroll taxes instead of your income tax. This payroll tax election may influence some businesses to undertake or increase their research activities. On the other hand, if you’re engaged in or are planning to engage in research activities without regard to tax consequences, be aware that some tax relief could be in your future.
Here are some answers to questions about the option.
Why is the election important?
Many new businesses, even if they have some cash flow, or even net positive cash flow and/or a book profit, pay no income taxes and won’t for some time. Therefore, there’s no amount against which business credits, including the research credit, can be applied. On the other hand, a wage-paying business, even a new one, has payroll tax liabilities. The payroll tax election is thus an opportunity to get immediate use out of the research credits that a business earns. Because every dollar of credit-eligible expenditure can result in as much as a 10-cent tax credit, that’s a big help in the start-up phase of a business — the time when help is most needed.
Which businesses are eligible?
To qualify for the election a taxpayer:
- Must have gross receipts for the election year of less than $5 million and
- Be no more than five years past the period for which it had no receipts (the start-up period).
In making these determinations, the only gross receipts that an individual taxpayer takes into account are from his or her businesses. An individual’s salary, investment income or other income aren’t taken into account. Also, note that neither an entity nor an individual can make the election for more than six years in a row.
Are there limits on the election?
Research credits for which a taxpayer makes the payroll tax election can be applied only against the employer’s old-age, survivors and disability liability — the OASDI or Social Security portion of FICA taxes. So the election can’t be used to lower 1) the employer’s liability for the Medicare portion of FICA taxes or 2) any FICA taxes that the employer withholds and remits to the government on behalf of employees.
The amount of research credit for which the election can be made can’t annually exceed $250,000. Note too that an individual or C corporation can make the election only for those research credits which, in the absence of an election, would have to be carried forward. In other words, a C corporation can’t make the election for research credits that the taxpayer can use to reduce current or past income tax liabilities.
The above Q&As just cover the basics about the payroll tax election. And, as you may have already experienced, identifying and substantiating expenses eligible for the research credit itself is a complex area. Contact us for more information about the payroll tax election and the research credit.
© 2022
June 22, 2022
Estate planning and business succession planning: The lines blur with a family business
For many business owners, estate planning and succession planning go hand in hand. As the owner of a closely held business, you likely have a significant portion of your wealth tied up in the business. If you don’t take the proper estate planning steps to ensure that the business lives on after you’re gone, you may be placing your family at risk.
Separate ownership and management succession
One reason transferring a family business can be a challenge is the distinction between ownership and management succession. When a business is sold to a third party, ownership and management succession typically happen simultaneously. But in the context of a family business, there may be reasons to separate the two.
From an estate planning perspective, transferring assets to the younger generation as early as possible allows you to remove future appreciation from your estate, minimizing any estate taxes due after your death. On the other hand, you may not be ready to hand over the reins or you may feel that your children aren’t ready to take over.
There are strategies family business owners can use to transfer ownership without immediately giving up control, including:
- Transferring ownership to the next generation in the form of nonvoting stock,
- Placing business interests in a trust, family limited partnership or other vehicle that allows the owner to transfer substantial ownership interests to the younger generation while retaining management control, or
- Establishing an employee stock ownership plan.
Another reason to separate ownership and management succession is to deal with family members who aren’t involved in the business. Providing heirs outside the business with nonvoting stock or other equity interests that don’t confer control can be an effective way to share the wealth while allowing those who work in the business to take over management.
Work around conflicts
Another unique challenge presented by a family business is that the older and younger generations may have conflicting financial needs. Fortunately, there are strategies available to generate cash flow for the owner while minimizing the burden on the next generation.
For example, you may want to structure an installment sale of the business to your heirs. This option can provide you liquidity while easing the burden on your adult children or other heirs. It may also improve the chances that the purchase can be funded by cash flows from the business. Plus, as long as the price and terms are comparable to arm’s-length transactions between unrelated parties, the sale shouldn’t trigger gift or estate tax.
Get an early start
Regardless of your strategy, the earlier you start planning the better. Transitioning the business gradually over several years or even a decade or more gives you time to educate family members about your succession planning philosophy. It also allows you to relinquish control over time, and to implement tax-efficient business structures and transfer strategies. Because each family business is different, work with us to identify appropriate strategies in line with your objectives and resources.
© 2022
May 25, 2022
Partners may have to report more income on tax returns than they receive in cash
Are you a partner in a business? You may have come across a situation that’s puzzling. In a given year, you may be taxed on more partnership income than was distributed to you from the partnership in which you’re a partner.
Why does this happen? It’s due to the way partnerships and partners are taxed. Unlike C corporations, partnerships aren’t subject to income tax. Instead, each partner is taxed on the partnership’s earnings — whether or not they’re distributed. Similarly, if a partnership has a loss, the loss is passed through to the partners. (However, various rules may prevent a partner from currently using his or her share of a partnership’s loss to offset other income.)
Pass through your share
While a partnership isn’t subject to income tax, it’s treated as a separate entity for purposes of determining its income, gains, losses, deductions and credits. This makes it possible to pass through to partners their share of these items.
An information return must be filed by a partnership. On Schedule K of Form 1065, the partnership separately identifies income, deductions, credits and other items. This is so that each partner can properly treat items that are subject to limits or other rules that could affect their correct treatment at the partner’s level. Examples of such items include capital gains and losses, interest expense on investment debts and charitable contributions. Each partner gets a Schedule K-1 showing his or her share of partnership items.
Basis and distribution rules ensure that partners aren’t taxed twice. A partner’s initial basis in his or her partnership interest (the determination of which varies depending on how the interest was acquired) is increased by his or her share of partnership taxable income. When that income is paid out to partners in cash, they aren’t taxed on the cash if they have sufficient basis. Instead, partners just reduce their basis by the amount of the distribution. If a cash distribution exceeds a partner’s basis, then the excess is taxed to the partner as a gain, which often is a capital gain.
Illustrative example
Two people each contribute $10,000 to form a partnership. The partnership has $80,000 of taxable income in the first year, during which it makes no cash distributions to the two partners. Each of them reports $40,000 of taxable income from the partnership as shown on their K-1s. Each has a starting basis of $10,000, which is increased by $40,000 to $50,000. In the second year, the partnership breaks even (has zero taxable income) and distributes $40,000 to each of the two partners. The cash distributed to them is received tax-free. Each of them, however, must reduce the basis in his or her partnership interest from $50,000 to $10,000.
More rules and limits
The example and details above are an overview and, therefore, don’t cover all the rules. For example, many other events require basis adjustments and there are a host of special rules covering noncash distributions, distributions of securities, liquidating distributions and other matters. Contact us if you’d like to discuss how a partner is taxed.
© 2022
May 25, 2022
What is a Prenuptial Agreement?
ACTEC Fellows Elizabeth R. Glasgow and Toni Ann Kruse explain what a prenuptial agreement is, why you should get one, when in the marriage planning process to discuss it.
May 23, 2022
A living will can help ensure your last medical wishes are carried out
According to a University of Pennsylvania report, approximately 37% of Americans have “advance directives,” which include living wills and power-of-attorney designations. These documents specify what should occur and who should make medical decisions should someone become seriously ill and unable to make these decisions for him- or herself.
If you belong to the other 63% or so of Americans who haven’t made such arrangements, put it at the top of your to-do list. Your peace of mind — and that of your family — depend on it.
Differentiate between documents
Many people confuse a living will with a last will and testament, but they aren’t the same. These separate documents serve different, but vital, purposes.
A last will and testament is what you probably think of when you hear the term “will.” This document details how your assets will be distributed when you die. A living will (or health care directive) details how life-sustaining medical treatment decisions would be made if you become incapacitated and unable to communicate them yourself.
The thought of becoming terminally ill or entering a coma isn’t pleasant, which is one reason many people put off creating a living will. However, it’s important to think through what you’d like to happen should this ever occur. A living will can provide guidance and reassurance to family members at a time they’re likely to be emotionally distressed.
Provide power of attorney
Often, a living will is drafted in conjunction with two other documents: a durable power of attorney for property and a health care power of attorney.
A durable power of attorney for property identifies someone who can handle your financial affairs, such as paying bills and undertaking other routine tasks, should you become incapacitated. The health care power of attorney becomes effective if you’re incapacitated, but not terminal or in a vegetative state. Your designee can make medical decisions on your behalf if you’re unable to do so. But this person can’t officially make life-sustaining choices. That requires a living will.
Enlist expert help
As tempting as do-it-yourself legal document kits may seem, it’s much better to work with an attorney when drafting a living will, durable power of attorney and power of attorney for health care. These documents are too important to get wrong. Another tip: Discuss the details of your living will and other directives with your loved ones so they’ll know what to expect should they ever be required to act.
© 2022
May 17, 2022
Addressing adopted children or stepchildren in your estate plan
Families that have children who are adopted, or stepchildren who haven’t been legally adopted, may face unique estate planning challenges. Additional consideration must be taken when a family includes an unmarried couple in a long-term relationship and one person has biological or adopted children. If your family’s makeup is as such, it’s important to understand your estate planning options.
Treated as equals
Adopted children are placed on an equal footing with biological children in most situations for estate planning purposes. Thus, adopted and biological children are treated the same way under a state’s intestate succession laws, which control who inherits property in the absence of a will.
In addition, adopted children generally are treated identically to biological children for purposes of wills or trusts that provide for gifts or distributions to a class of persons, such as “children,” “grandchildren” or “lineal descendants” — even if the child was adopted after the will or trust was executed.
No inheritance rights unless adopted
Stepchildren generally don’t have any inheritance rights with respect to their parents’ new spouses unless the spouse legally adopts them. If you have stepchildren and want them to share in your estate, either adopt them or amend your estate plan to provide for them expressly.
Of course, estate planning isn’t the only reason to adopt stepchildren. Adoption also gives you the legal rights of a parent during your life.
Before you adopt stepchildren, however, you and your spouse should consider the potential effect on their ability to inherit from (or through) their other biological parent and his or her relatives. In most states, when a child is adopted by a stepparent, the adoption decree severs the parent-child relationship with the other biological parent and his or her family. That means the child can’t inherit from that biological parent’s branch of the family — and vice versa — through intestate succession.
Second-parent adoption considerations
A growing minority of states now permit second-parent adoptions, in which an unmarried person adopts his or her partner’s biological or adopted children without terminating the partner’s parental rights. However, in states that recognize second-parent adoptions, their intestate succession laws may not provide for a child to inherit from the “second parent.”
Spell out your wishes
If you have children who are adopted or stepchildren whom you haven’t legally adopted, or you’re unmarried but in a long-term relationship and your partner has biological or adopted children, clearly address your intentions in your will or living trust. Your estate planning advisor can help you understand your options.
© 2022