February 11, 2020
BDIT lets you give away property without losing control
By temporarily doubling the gift and estate tax exemption, the Tax Cuts and Jobs Act (TCJA) opened a window of opportunity for affluent families to transfer assets tax-free. To take advantage of the higher exemption amount, many families that own businesses or other assets worth more than the pre-TCJA exemption amount are planning substantial gifts to their children before 2026.
Traditionally, parents use trust-based gifting strategies to transfer assets to their children. Even though these strategies offer significant tax-planning benefits, they also have a major drawback: They require you to relinquish much of your control over the assets, including the right to direct the ultimate disposition of the trust assets. One strategy for avoiding this drawback is to use a beneficiary defective inheritor’s trust (BDIT).
It’s better to receive than to give
The tax code prevents you from transferring assets in trust to your children or other beneficiaries on a tax-advantaged basis if you retain the right to use or control those assets. But similar restrictions don’t apply to assets you receive as beneficiary of a third-party trust. This distinction is what makes a BDIT work. The strategy is best illustrated with an example:
Let’s say John owns a business valued at $12 million (just over the current exemption amount of $11.4 million) and it’s organized as a limited liability company (LLC). He’d like to take advantage of the exemption by transferring ownership of the business to his three children. But he’s not ready to relinquish control over the business. John arranges for his parents to establish three BDITs, each naming him as primary beneficiary and one of his children as contingent beneficiaries. He then sells a one-third interest in the LLC to each trust for $3 million. The sale price of each interest reflects a 25% minority interest discount.
As a result, John:
- Removes the value of the business and all future appreciation from his estate without triggering gift tax liability,
- Provides the trust assets with some protection against creditors’ claims,
- Retains the right as beneficiary to manage the trust assets, to receive trust income, to withdraw trust principal for his “health, education, maintenance or support,” and to receive additional distributions at the independent trustee’s discretion,
- Retains the right to remove and replace the trustee, and
- Enjoys a special power of appointment to distribute the trust assets (so long as it’s not for his benefit).
For this strategy to pass muster with the IRS, a couple of things must happen. First, to ensure that the BDITs have economic substance, John’s parents should “seed” each trust with cash — typically at least 10% of the purchase price, in this case $300,000 per trust.
Second, to avoid negative tax consequences for John’s parents, the trusts must be “beneficiary defective,” ensuring that John is treated as grantor for income tax purposes. Typically, this is accomplished by granting John lapsing powers to withdraw funds from the trust.
Bear in mind that implementing this strategy is complex, but it can offer significant estate tax benefits. Contact us before taking action.
© 2019
February 11, 2020
Determining Whether You Need to File a Gift Tax Return Can Be Tricky
For 2020, the lifetime gift and estate tax exemption has reached a whopping $11.58 million ($23.16 million for married couples). As a result, few people will be subject to federal gift taxes.
If your wealth is well within the exemption amount, does that mean there’s no need to file gift tax returns? Not necessarily. There are many situations in which it’s necessary (or desirable) to file Form 709 — “United States Gift (and Generation-Skipping Transfer) Tax Return” — even if you’re not liable for any gift taxes.
If you’re required to file, keep in mind that the deadline for Form 709 is April 15 of the year after you make a gift.
All gifts are taxable, except . . .
The federal gift tax regime begins with the assumption that all transfers of property by gift (including below-market sales or loans) are taxable, and then sets forth several exceptions. Some of the nontaxable transfers that need not be reported on Form 709 include:
- Gifts of present interests (see below) within the annual exclusion amount (currently, $15,000 per donee),
- Deductible charitable gifts, and
- Gifts to one’s U.S.-citizen spouse, either outright or to a trust that meets certain requirements.
If all your gifts for the year fall into these categories, no gift tax return is required. But other types of gifts may be taxable — and must be reported on Form 709 — even if they’re shielded from tax by the lifetime exemption.
Traps to avoid
If you make gifts during the year, consider whether you’re required to file Form 709. And watch out for these common traps:
Future interests. The $15,000 annual exclusion applies only to present interests, such as outright gifts. Gifts of future interests, such as transfers to a trust for a donee’s benefit, aren’t covered, so you’re required to report them on Form 709 even if they’re less than $15,000.
Spousal gifts. As previously noted, gifts to a U.S.-citizen spouse need not be reported on Form 709. However, if you make a gift to a trust for your spouse’s benefit, the trust must 1) provide that your spouse is entitled to all the trust’s income for life, payable at least annually, 2) give your spouse a general power of appointment over its assets and 3) not be subject to any other person’s power of appointment. Otherwise, the gift must be reported.
Gift splitting. Spouses may elect to split a gift to a child or other donee, so that each spouse is deemed to have made one-half of the gift, even if one spouse wrote the check. This allows married couples to combine their annual exclusions and give up to $30,000 to each donee. To make the election, the donor spouse must file Form 709, and the other spouse must sign a consent or, in some cases, file a separate gift tax return.
To file or not to file
To keep from running afoul of the IRS, it’s critical to know when you need to file a gift tax return. We can help you in that determination.
© 2020
February 11, 2020
February 10, 2020
Don’t Worry! A Broken Trust Can Be Fixed
There are good reasons why estate planning advisors recommend you revisit and, if necessary, revise your estate plan periodically: changing circumstances, including family situations and new tax laws. While it’s relatively simple to change a beneficiary, what if an irrevocable trust no longer serves your purposes? Depending on applicable state law, you may have options to fix a “broken” trust.
Reasons why a trust can break
A trust that works just fine when it’s established may no longer achieve its original goals if your family circumstances change. If you divorce, for example, a trust for the benefit of your spouse may no longer be desirable. If your children grow up to be financially independent, they may prefer that you leave your wealth to their children. Or perhaps you prefer not to share your wealth with a beneficiary who has developed a drug or alcohol problem or has proven to be profligate.
Another reason is new tax laws. Many trusts were created when gift, estate and generation-skipping transfer (GST) tax exemption amounts were relatively low. Today, however, the exemptions have risen to $11.4 million, so trusts designed to minimize gift, estate and GST taxes may no longer be necessary. And with transfer taxes out of the picture, the higher income taxes often associated with these trusts — previously overshadowed by transfer tax concerns — become a more important factor.
Here are possible remedies
If you have one or more trusts in need of repair, you may have several remedies at your disposal, depending on applicable law in the state where you live and, if different, in the state where the trust is located. Potential remedies include:
Re-formation. The Uniform Trust Code (UTC), adopted in more than half the states, provides several remedies for broken trusts. Non-UTC states may provide similar remedies. Re-formation allows you to ask a court to rewrite a trust’s terms to conform with the grantor’s intent. This remedy is available if the trust’s original terms were based on a legal or factual mistake.
Modification. This remedy may be available, also through court proceedings, if unanticipated circumstances require changes in order to achieve the trust’s purposes. Some states permit modification — even if it’s inconsistent with the trust’s purposes — with the consent of the grantor and all the beneficiaries.
Decanting. Many states have decanting laws, which allow a trustee, according to his or her distribution powers, to “pour” funds from one trust into another with different terms and even in a different location. Depending on your circumstances and applicable state law, decanting may allow a trustee to correct errors, take advantage of new tax laws or another state’s asset protection laws, add or eliminate beneficiaries, extend the trust term, and make other changes, often without court approval.
Before you make any changes, it’s critical to consult your attorney and tax advisor to discuss the potential benefits and risks.
© 2019
February 10, 2020
February 10, 2020
Who Needs an Estate Plan? You Do!
Despite what you might think, estate planning isn’t limited to only the rich and famous. In fact, your family is likely to benefit from a comprehensive plan that divides your wealth, protects your well-being and provides a compass for your family’s future.
Dividing your wealth
Estate planning is often associated with the division of your assets, and this is certainly a key component. It’s typically accomplished, for the most part, by drafting a will, which is the foundation of an estate plan.
With a valid will, you determine who gets what. It can cover everything from the securities in your portfolio to personal property, such as cars, artwork or other family heirlooms.
In contrast, if you die without a will — referred to as dying “intestate” — state law will control the disposition of your assets. This may result in unintended consequences. For example, children from a prior marriage may be excluded if state law dictates that all assets are to go to a surviving spouse.
In addition, you’ll need to name the executor of your estate. He or she will be responsible for carrying out your wishes according to your will. Your executor may be a professional, a family member or a friend. Also, designate a successor in case your first choice is unable to handle the duties.
Understanding probate
If your estate plan includes only a will, your estate will most likely have to go through probate. Probate is a court-supervised process to protect the rights of creditors and beneficiaries and to ensure the orderly and timely transfer of assets. The complexity and duration of probate depends on the size of your estate and state law.
If you transfer assets to a living trust, those assets are exempt from the probate process. Thus, a living trust may supplement a will, giving heirs fast access to funds.
Protecting your well-being
An estate plan can help ensure that your long-term health care is handled in the way that you wish. Notably, you can create a health care power of attorney. It grants another person — for example, a family member or a friend — the right to act on your behalf in the event you’re incapacitated. A power of attorney may be coordinated with a living will specifying your wishes in end-of-life situations, along with other health care directives.
Providing a compass
Finally, an estate plan can accomplish a variety of other objectives, depending on your preferences and circumstances. If you have minor children, you can name a guardian in your will in the event of your premature death. Without such a provision, the courts will appoint a guardian, regardless of your intent.
Your estate plan can also protect against creditors, primarily through trusts designed for these purposes. Accordingly, while trusts were often seen mainly as tax-saving devices in the past, they can fulfill a multitude of other roles.
Let the planning begin
Now that the need for an estate plan is clear, don’t delay any longer. Contact us to begin the process or if you have any questions.
© 2019
February 10, 2020
Leave a Philanthropic Legacy with a Charitable Remainder Trust
Let’s say you’re charitably inclined but have concerns about maintaining a sufficient amount of income to meet your current needs. The good news is that there’s a trust for that: a charitable remainder trust (CRT). This type of trust allows you to support your favorite charity while potentially boosting cash flow, shrinking the size of your taxable estate, and reducing or deferring income taxes.
A CRT in action
You contribute stock or other assets to an irrevocable trust that provides you — and, if you desire, your spouse — with an income stream for life or for a term of up to 20 years. (You can name a noncharitable beneficiary other than yourself or your spouse, but there may be gift tax implications.) At the end of the trust term, the remaining trust assets are distributed to one or more charities you’ve selected.
When you fund the trust, you can claim a charitable income tax deduction equal to the present value of the remainder interest (subject to applicable limits on charitable deductions). Your annual payouts from the trust can be based on a fixed percentage of the trust’s initial value — known as a charitable remainder annuity trust (CRAT). Or they can be based on a fixed percentage of the trust’s value recalculated annually — known as a charitable remainder unitrust (CRUT).
CRUTs vs. CRATs
Generally, CRUTs are preferable for two reasons. First, the annual revaluation of the trust assets allows payouts to increase if the trust assets grow, which can allow your income stream to keep up with inflation. Second, you can make additional contributions to CRUTs, but not to CRATs.
The fixed percentage — called the unitrust amount — can range from 5% to 50%. A higher rate increases the income stream, but it also reduces the value of the remainder interest and, therefore, the charitable deduction. Also, to pass muster with the IRS, the present value of the remainder interest must be at least 10% of the initial value of the trust assets.
The determination of whether the remainder interest meets the 10% requirement is made at the time the assets are transferred — it’s an actuarial calculation based on the trust’s terms. If the ultimate distribution to charity is less than 10% of the amount transferred, there’s no adverse tax impact related to the contribution.
Seek advice before acting
CRTs require careful planning and solid investment guidance to ensure that they meet your needs. Before taking action, discuss your options with us.
© 2019
February 10, 2020
The Chances of an IRS Audit are Low, but Business Owners Should be Prepared
Many business owners ask: How can I avoid an IRS audit? The good news is that the odds against being audited are in your favor. In fiscal year 2018, the IRS audited approximately 0.6% of individuals. Businesses, large corporations and high-income individuals are more likely to be audited but, overall, audit rates are historically low.
There’s no 100% guarantee that you won’t be picked for an audit, because some tax returns are chosen randomly. However, completing your returns in a timely and accurate fashion with our firm certainly works in your favor. And it helps to know what might catch the attention of the IRS.
Audit red flags
A variety of tax-return entries may raise red flags with the IRS and may lead to an audit. Here are a few examples:
- Significant inconsistencies between previous years’ filings and your most current filing,
- Gross profit margin or expenses markedly different from those of other businesses in your industry, and
- Miscalculated or unusually high deductions.
Certain types of deductions may be questioned by the IRS because there are strict recordkeeping requirements for them • for example, auto and travel expense deductions. In addition, an owner-employee salary that’s inordinately higher or lower than those in similar companies in his or her location can catch the IRS’s eye, especially if the business is structured as a corporation.
How to respond
If you’re selected for an audit, you’ll be notified by letter. Generally, the IRS won’t make initial contact by phone. But if there’s no response to the letter, the agency may follow up with a call.
Many audits simply request that you mail in documentation to support certain deductions you’ve taken. Others may ask you to take receipts and other documents to a local IRS office. Only the harshest version, the field audit, requires meeting with one or more IRS auditors. (Note: Ignore unsolicited email messages about an audit. The IRS doesn’t contact people in this manner. These are scams.)
Keep in mind that the tax agency won’t demand an immediate response to a mailed notice. You’ll be informed of the discrepancies in question and given time to prepare. You’ll need to collect and organize all relevant income and expense records. If any records are missing, you’ll have to reconstruct the information as accurately as possible based on other documentation.
If the IRS chooses you for an audit, our firm can help you:
- Understand what the IRS is disputing (it’s not always crystal clear),
- Gather the specific documents and information needed, and
- •Respond to the auditor’s inquiries in the most expedient and effective manner.
Don’t panic if you’re contacted by the IRS. Many audits are routine. By taking a meticulous, proactive approach to how you track, document and file your company’s tax-related information, you’ll make an audit much less painful and even decrease the chances that one will happen in the first place.
© 2019
February 10, 2020
Sec. 6166: Estate Tax Relief for Family Businesses
Fewer people currently are subject to transfer taxes than ever before. But gift, estate and generation-skipping transfer (GST) taxes continue to place a burden on families with significant amounts of wealth tied up in illiquid closely held businesses, including farms.
Fortunately, Internal Revenue Code Section 6166 provides some relief, allowing the estates of family business owners to defer estate taxes and pay them in installments if certain requirements are met.
Sec. 6166 benefits
For families with substantial closely held business interests, an election to defer estate taxes under Sec. 6166 can help them avoid having to sell business assets to pay estate taxes. It allows an estate to pay interest only (at modest rates) for four years and then to stretch out estate tax payments over 10 years in equal annual installments. The goal is to enable the estate to pay the taxes out of business earnings or otherwise to buy enough time to raise the necessary funds without disrupting business operations.
Be aware that deferral isn’t available for the entire estate tax liability. Rather, it’s limited to the amount of tax attributable to qualifying closely held business interests.
Sec. 6166 requirements
Estate tax deferral is available if 1) the deceased was a U.S. citizen or resident who owned a closely held business at the time of his or her death, 2) the value of the deceased’s interest in the business exceeds 35% of his or her adjusted gross estate, and 3) the estate’s executor or other personal representative makes a Sec. 6166 election on a timely filed estate tax return.
To qualify as a “closely held business,” an entity must conduct an active trade or business at the time of the deceased’s death (and only assets used to conduct that trade or business count for purposes of the 35% threshold). Merely managing investment assets isn’t enough.
In addition, a closely held business must be structured as:
- A sole proprietorship,
- A partnership (including certain limited liability companies taxed as partnerships), provided either 1) 20% or more of the entity’s total capital interest is included in the deceased’s estate, or 2) the entity has a maximum of 45 partners, or
- A corporation, provided either 1) 20% or more of the corporation’s voting stock is included in the deceased’s estate, or 2) the corporation has a maximum of 45 shareholders.
Several special rules make it easier to satisfy Sec. 6166’s requirements. For example, if an estate holds interests in multiple closely held businesses, and owns at least 20% of each business, it may combine them and treat them as a single closely held business for purposes of the 35% threshold. In addition, the section treats stock and partnership interests held by certain family members as owned by the deceased.
On the other hand, the interests owned by corporations, partnerships, estates and trusts are attributed to the underlying shareholders, partners or beneficiaries. This can make it harder to stay under the 45-partner/shareholder limit.
Contact us with questions.
© 2019
February 10, 2020
How to Treat Your Business Website Costs for Tax Purposes
These days, most businesses need a website to remain competitive. It’s an easy decision to set one up and maintain it. But determining the proper tax treatment for the costs involved in developing a website isn’t so easy.
That’s because the IRS hasn’t released any official guidance on these costs yet. Consequently, you must apply existing guidance on other costs to the issue of website development costs.
Hardware and software
First, let’s look at the hardware you may need to operate a website. The costs involved fall under the standard rules for depreciable equipment. Specifically, once these assets are up and running, you can deduct 100% of the cost in the first year they’re placed in service (before 2023). This favorable treatment is allowed under the 100% first-year bonus depreciation break.
In later years, you can probably deduct 100% of these costs in the year the assets are placed in service under the Section 179 first-year depreciation deduction privilege. However, Sec. 179 deductions are subject to several limitations.
For tax years beginning in 2019, the maximum Sec. 179 deduction is $1.02 million, subject to a phaseout rule. Under the rule, the deduction is phased out if more than a specified amount of qualified property is placed in service during the year. The threshold amount for 2019 is $2.55 million.
There’s also a taxable income limit. Under it, your Sec. 179 deduction can’t exceed your business taxable income. In other words, Sec. 179 deductions can’t create or increase an overall tax loss. However, any Sec. 179 deduction amount that you can’t immediately deduct is carried forward and can be deducted in later years (to the extent permitted by the applicable limits).
Similar rules apply to purchased off-the-shelf software. However, software license fees are treated differently from purchased software costs for tax purposes. Payments for leased or licensed software used for your website are currently deductible as ordinary and necessary business expenses.
Software developed internally
If your website is primarily for advertising, you can also currently deduct internal website software development costs as ordinary and necessary business expenses.
An alternative position is that your software development costs represent currently deductible research and development costs under the tax code. To qualify for this treatment, the costs must be paid or incurred by December 31, 2022.
A more conservative approach would be to capitalize the costs of internally developed software. Then you would depreciate them over 36 months.
Third party payments
Some companies hire third parties to set up and run their websites. In general, payments to third parties are currently deductible as ordinary and necessary business expenses.
Before business begins
Start-up expenses can include website development costs. Up to $5,000 of otherwise deductible expenses that are incurred before your business commences can generally be deducted in the year business commences. However, if your start-up expenses exceed $50,000, the $5,000 current deduction limit starts to be chipped away. Above this amount, you must capitalize some, or all, of your start-up expenses and amortize them over 60 months, starting with the month that business commences.
We can help
We can determine the appropriate treatment for these costs for federal income tax purposes. Contact us if you have questions or want more information.
© 2019