Vol. 84, No. 2, February 2011
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In this video, author Robert Mathers gives an overview of the 2010 Tax Relief Act, highlighting the tax-planning opportunities that lawyers can present to clients. You also can find this video at YouTube.com/StateBarofWI, and in the Feb. 2 InsideTrack.
On Dec. 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Pub. L. No. 111-312 (Tax Relief Act). In addition to extending the Bush-era tax cuts, the new law provides for an alternative minimum tax (AMT) “patch,” a one-year payroll-tax cut, 100 percent bonus depreciation through 2011, and additional income tax breaks. The new law also adopts a new, 24-month estate tax holiday for decedents dying in 2010, 2011, or 2012, a new 35 percent unified gift and estate tax rate, a $5 million transfer tax exclusion (per person), and additional benefits detailed below.
The new law contains several unique planning opportunities, but it is also fraught with peril for those not paying attention to the details. It is the first time since 1915 that the United States has had no federal estate tax and the first time since 1976 that there has been no generation-skipping transfer tax. But the window for these and other provisions closes very quickly.
From a tax-planning perspective, the new law makes the following themes crucial for lawyers and their clients to consider over the next three years.
Business owners contemplating expansion of existing property, facilities, or equipment must carefully correlate the acquisition and financing with the new depreciation rules.
For example, the depreciation deductions allowed for business use of passenger automobiles have increased under the new bonus-depreciation rules. Before the new law, this type of equipment typically would have been subject to a maximum depreciation deduction in the first year of about $3,000. For 2010, under the new law, the maximum first-year depreciation deduction is $11,060 for passenger automobiles and $11,160 for light trucks.
However, business owners need to consider their overall strategy before jumping into the new depreciation rules. In the construction industry, for example, back orders and net income are both down, and so purchasing new equipment to generate a possible deduction may not be advisable, particularly if the purchase increases interest expense with no other immediate benefit (that is, the losses may or may not carry forward). See the accompanying sidebar for an example.
Note that if clients find that their lower tax brackets are not being efficiently used, they can choose to electively decline the bonus depreciation. This is done by attaching a statement to the taxpayer’s income tax return. Generally speaking, the taxpayer’s total depreciation deduction is maximized if section 179 elections are used on assets not qualifying for the bonus-depreciation regime (for example, used-equipment additions). If the combination of methods is more than what is needed to get to the taxpayer’s targeted taxable income, it is wise to consider using the bonus depreciation and deferring the section 179 deduction. The latter can be claimed on a subsequently filed amended return if the taxpayer’s income goes up, whereas bonus depreciation is lost if not claimed on an originally filed return.
Family Businesses in Transition
Family businesses in transition have a limited window of high gift-tax exemption, low transfer tax, reinstatement of the qualified family-owned business incentives, and reduced payroll taxes before the health-care surtaxes start in 2013.
Although for many people the $5 million gift-tax exemption and portability of a surviving spouse’s $5 million unified-credit exemption is more of a pipe dream than a planning tool, the tax savings are significant to people it affects. Family-owned businesses are affected by these new opportunities for many reasons, including low interest rates; generally lower equity-risk premiums, which result in lower valuations for closely held stock and real estate; and the ability to use life insurance to create liquidity when needed.
Just focusing on the life insurance issue alone, under the old rules of $1 million exemptions, family-owned businesses had to think of creative ways to fit gifts of cash into the $13,000 annual gift-tax exemptions. The annual gift-tax exemptions often were used to fund life insurance policies inside of life insurance trusts that were used for either estate liquidity or estate equalization. Now that the gift tax exemption has been raised by 500 percent in 2011 and 2012, a married couple can transfer a paid-up life insurance policy into an irrevocable life insurance trust and use up part of their $5 million gift-tax exemption. In future years, other assets can be passed through the $13,000 gift-tax annual exclusion window (for example, interests in closely held stock, where the fair market value is net of valuation discounts). The future $13,000 annual exclusion amounts, in this instance, would no longer be occupied by gifts used to pay premiums on the life insurance contract, and the transferor can retain a controlling interest in the property being gifted, since minority interests would continue to pass through the future annual exclusion windows.
So while few individuals can afford to give away $5 million of assets just because the new law allows them to do so until the end of next year, many family-owned businesses should take this opportunity to properly adjust their business, real estate, and insurance plans. Planning, however, is still needed for married clients between the $1 million and $10 million net- worth levels. As an example, a married couple with a net worth of $8 million, assuming they could live on $2 million of assets for the rest of their lives, could eliminate the estate tax by making transfers before the end of 2012.
By retaining their $2 million of retirement assets in their name, and transferring the remaining $6 million of assets the couple can use up $6 million of their new gift-tax exemptions. Under current legislation, the unified credit will return to $1 million each after Dec. 31, 2012, and the couple can minimize the effect of the estate tax, having transferred not only $6 million of “excess” assets, but also the appreciation on that $6 million during this two-year estate and gift tax holiday.
On the flip side, many people will be lulled into a false conclusion that they can just walk away from life insurance policies that were once used to fund the estate tax. Assume a married couple, both age 55, have assets that, for estate tax purposes, are worth $5 million. Although future growth and expenditures are never certain, it is reasonable to project that their assets will grow to $10 million by the time they are 85 years old (assumed age of death).
A few years ago, the couple bought a $2.5 million life insurance policy that they placed in an irrevocable life insurance trust to help pay for the estate taxes, because part of their portfolio was invested in an illiquid closely held business and related real estate. At the time, $2.5 million was the projected estate-tax-liability shortfall.
The couple contributes $20,000 in gifts to the life insurance trust, which, in turn, funds the second-to-die life insurance policy. The gifts are necessary, but they cause a cash drain and use up some of the couple’s $26,000 annual gift-tax exemption ($13,000 for each person), which they could be using to transfer stock to their children.
When the couple learns of the new $5 million exemption, they visit their lawyer with one question in mind: can we walk away from the life insurance trust and the policy it owns? This would be a terrible idea for several reasons:
1) The $5 million exemption lasts only until the end of 2012, when it is scheduled to revert back to $1 million, putting the couple back into an estate tax liquidity shortfall.
2) To take advantage of the $5 million exemption, both spouses would have to die before Dec. 31, 2012.
3) The clients have only a brief window of opportunity (two years) to pay up the life insurance policy with a one-time gift into the trust and thereby free up future annual exclusions for gifts of the real estate or closely held stock over a period of time suitable to the next generation’s ability to run the business.
Energy Tax Credits
Energy tax credits and grants are significant. Taxpayers need to follow arcane application and qualification rules to qualify for incentives, whether the project is commenced in 2010, 2011, or 2012. The new law extends more than 50 tax credits through the end of 2011.
For example, the developer of a qualifying energy project is eligible to receive an investment tax credit equal to 10 percent to 30 percent of basis for certain types of renewable energy equipment. Treasury grants are also available and provide equivalent dollar-amount benefits as the investment tax credit(s).
The grants, however, are designed to benefit, not just the developer, but also a lessee of the equipment. With the time extensions afforded by the 2010 Tax Reform Act, developers may now think about attracting investors to create energy consortiums that are able to lease the equipment. A few structures would be available for the investors to share in the grants, as follows:
1) An income-oriented investor group may acquire the property at a desired rate of return and then “flip” the investment back to the developer through a “put option” (buying the right to sell at a certain price) – a so-called put partnership.
2) Another way to take advantage of the grants would be to speculate on the development of a renewable energy facility and then sell the facility to an investor group, which leases the facility back to the developer, who retains the opportunity to reacquire the property at the end of the lease term.
3) Finally, a very aggressive developer might lease the facility to a group of investors and elect to pass the tax credit or Treasury grant through to the investors, who operate the facility and make lease payments back to the developer.
In any of the above hypothetical structures, clients and advisors need to verify compliance with meticulous provisions of the credit or grant.1
Structure for Tax-free Business Growth
Business owners contemplating external growth (through mergers or acquisitions or by restructuring for organic growth) need to consider the opportunity for potential tax-free sale of stock.
For stock acquired after Sept. 27, 2010, held for five years, and properly capitalized, an investor can eliminate up to $10 million of capital gain from taxation. Before the new law, the acquisition had to be completed by Jan. 1, 2011. Under the new law, the 100% percent gain exclusion is extended to stock acquired before Jan. 1, 2012. Some of the technical aspects of forming the new company can be complex. But the pay-off can be huge. To qualify for this treatment, the stock must consist of newly issued shares in a C corporation and be held until at least 2015, and the corporation must use at least 80 percent of the value of its assets in the active pursuit of one or more qualified trades or businesses.
Robert A. Mathers, William Mitchell 1990, CPA, is a shareholder in Davis & Kuelthau, Oshkosh, practicing primarily in the corporate area. He also holds credentials from the American Institute of CPAs (AICPA) as an ABV (business valuation) and PFS (personal financial specialist). He provides legal and advisory services to Wisconsin corporations and their owners, focusing on closely held businesses, and estate planning and private wealth services to individuals. He previously was national tax director at one of the country’s largest CPA firms. Contact him at firstname.lastname@example.org.
Project Taxes for a Rolling Three-year Horizon
It has never been more crucial for individual clients to maintain an ongoing tax projection for a rolling three-year horizon to ensure proper coordination of the 0.0 percent capital-gain tax rates, a myriad of tax credits, and AMT provisions that come and go, in addition to the normal itemized deductions.
For example, deciding whether to convert a traditional individual retirement account (IRA) to a Roth IRA has been widely publicized. If the conversion was made in 2010, the taxable income automatically will be allocated evenly between 2011 and 2012, unless the taxpayer elects to have it brought into 2010. With the new tax law extending the 2011 and 2012 lower income tax rates (from a top rate of 39.6 percent to a top rate of 35 percent), the Roth IRA conversion question is alive for two more years. For many people, converting to a Roth IRA was a way to avoid the income tax surcharge for the health-care reform provisions that begin in 2013. For others, the Roth IRA conversion created a source of tax-free retirement income, and paying at the highest marginal rate of 35 percent was a bargain, compared to the 39.6 percent rate that comes into play in 2013. Still others converted in search of protection from the required minimum-distribution rules, which may have compelled them to take distributions at the highest federal income tax rates for future distributions.
Another example of individual income tax planning has to do with required IRA distributions. Congress reinstated the I.R.C. § 725 treatment of qualified distributions of IRAs to charities for the period Jan. 1, 2010 to Dec. 31, 2011. The same limitations apply – for example, there is a $100,000 limitation per individual and the individual must have passed the required start date (age 70 1/2). In addition, the qualified distribution will be treated as though it occurred in 2010 for 2010 required minimum distributions (according to the committee reports). So, if a client makes this type of distribution, he or she does not report the qualified distribution as income, but he or she also cannot list it as a charitable deduction on his or her income tax return. The transfer must be made directly from the custodian or trustee to the charity.
These two examples alone illustrate ways in which individuals can dramatically control their taxable income from required minimum distributions of tax-qualified assets. Clients need to remember that the lower tax rates only last through the end of 2012; absent Congressional change, the tax rates go back up in 2013, when the surtax on certain income to fund the new health-care package also goes into effect.
Plan for Reinstatement of Pre-2010 Tax Law
For clients with estates of more than $1 million of net worth, it is crucial to not ease up in planning for the Jan. 1, 2013, reinstatement of the “Bush Era” pre-2001 estate and gift tax law ($1 million gift and estate tax exemptions; 55 percent top tax rate). Expect hot debate on this subject in 2012, a presidential election year, because although the estate tax represents a relatively small amount of revenue for the government, the tax is heavy on social policy.
It appears that planners will have two full years to work with the new law. However, the 2010 legislation leaves much to be desired as it relates to any type of post-2012 certainty of outcome, and it postpones the inevitable return to the pre-2001 tax regime.
Passage of the 2010 Tax Relief Act provides for some near-term certainty but delays many issues to 2012. The 2013 tax increases needed to help fund the 2010 health-care legislation are still set to go into effect after Dec. 31, 2012. The new Congress is at a fork in the road. Our legislators could take limited, but crucial, action and address only temporary tax laws that expire in 2011, and then address the provisions that expire in 2012 and keep the rest of a very complicated tax code. In the alternative, Congress could take on critical debates that are relics from 2001. In the latter scenario, questions will be asked regarding the nation’s deficit, spending cuts, and broad-based revenue enhancements. Indeed, the Act was a compromise and, as with many compromises, there are winning provisions and losing provisions. Whatever the outcome, as planners, we look for more stability to legislation so that we can be more proactive in helping our clients attain their desired goals.
1Additional information is available at www.irs.gov/newsroom/article/0,,id=209564,00.html.